Home > finance, hedge funds > Motivating transparency: what we could do about too big to fail

Motivating transparency: what we could do about too big to fail

July 13, 2011

In this previous post, I promised a follow-up post about how we can devise a system in which large banks are actually motivated to be transparent about what is inside their portfolios. We have also discussed why the current system doesn’t work this way and that the banks have every reason to obfuscate their holdings, and in fact make loads of money by doing so. This makes appropriate external risk management difficult or impossible.

I have actually thought about this problem quite a bit since that post, and I (and a friend in finance) have come up with two quasi ideas, which hopefully together add up to be as good as one complete idea. The first comes under the category, “add stuff to what we have now”, whereas the second comes under the category, “initiate a new system which will over time replace the one we have”. Both of these systems rely on a good understanding of the underlying problem of the current system, namely the concept of “too big to fail.”

If you’re reading this and you have comments about either idea, please do comment. We are hoping for lots of feedback so we can improve the details.

Too Big to Fail

Recall that the way it works when hedge funds want to trade stuff: they have prime brokers, i.e. banks like Deutche and Goldman Sachs and Bank of America (see list of the biggies here). When the brokers don’t like the trade, or think it’s not sufficiently liquid, or think that the hedge fund may fail for any reason, they demand that the hedge funds post margin. That way if the bet goes sour there is a limited amount of risk that the brokerage could lose. As soon as a position starts to look riskier, which could happen because of recent volatility or lack of price transparency, the amount of margin that needs to be posted normally increases, putting pressure on the hedge fund to liquidate suspicious assets.

In other words, there is a real cost to hedge funds for trading in illiquid or complex securities, namely their cash is tied up in bank accounts with their brokers. This is not to say that they don’t take large risks, but there is a limit of how much risk they can take because of the “posting margin” system.

By contrast, big banks don’t post margins. They trade with hedge funds, of course, since hedge funds trade with them, but it’s the banks who demand margin, not the hedge funds (actually there’s a historical exception to this rule, namely Paulson’s hedge fund demanded margin from its brokers during the 2008 financial crisis).

This asymmetrical situation begs the question, why do hedge funds have to post margin but the big banks don’t? Two reasons: first, banks have access to Federal funds, and second, they are deemed to big to fail. [I admit I don’t know exactly why the access to Federal funds is granted to banks, nor do I understand exactly what the effect is. But I do think it’s a pertinent fact which is why I’ve included it here. Please do comment if you know more! Also note it may be a red herring since Goldman Sachs didn’t have access to Fed funds until the crisis.]

This “too big to fail” guarantee is a huge problem, which has only gotten more precise (since we’ve seen the bailout and now everyone knows the guarantee is there) and larger (because, in the end, the net result of all the 2008 crisis is fewer, larger banks) and about which absolutely nothing seems to be getting done. The disingenuous whining of greedy bankers like Jamie Dimon serves as a smokescreen for the fact that, if anything, banks are presumably waltzing into the next phase of their life with more power and fewer checks than they could have dreamed about in August 2008.

Idea #1: make banks post margins

“Too big to fail” means that it is assumed that the bank will be rescued by the government if it makes huge bad bets that threaten to bring them down. Two of the reasons the government can be counted on to bail out banks are first, that the deposits of normal Americans are at risk, which is discussed below in Idea #2, and second, that a bankruptcy would be catastrophically complicated, which we discuss here. One result of the guarantee is that hedge funds don’t bother demanding margins, which makes the banks riskier, which makes the “too big to fail” guarantee even worse.

What if the lawmakers enforced a symmetry of posted margins? We have to be precise, because actually there are different kinds of margins that traders are forced to post.

First, there’s the margin you post in the sense of “keep $x as a deposit for the position”, the thinking being that even if things go south, the broker could liquidate at something better than $x below current marked price in a hurry. This is the initial margin.
Next there’s the “your position lost $10 today, so you need to give me $10” (this is called variation margin). This is the most likely way to get margin called.

The idea here is to require brokers to post initial margin just as hedge funds do now. More precisely, the idea would be to let the two parties negotiate on the initial margin, which could be more for hedge funds since they may well be riskier, but then once it’s set to have complete symmetry of variation margin.

Occasionally, in risky environments, the initial margin of $x is increased, which causes a lot of unraveling, and possibly cascading waves of problems which set off a panic. We’d need to have rules about how often this can happen to avoid the “symmetric of variation margin” rule from being bypassed with lots of initial margin modifications. The symmetry aspect should keep the margin contracts from allowing this to happen too often.

The overall goal would be to devise a system that would:

  1. Encourage the posting and calling of (variation) margins,
  2. Encourage sufficient sizing of initial margin,
  3. Encourage early calls and liquidating if there is doubt that a variation margin call could be met, and
  4. Simplify the bankruptcy rules on ownership of assets, especially for illiquid or complex assets.

The initial margin can be thought of as the dollar amount a price could move by between a margin call and it being paid. It should not be thought of as an asset for either party (and therefore the accounting of the various margins should be carefully considered, but I’m no accounting expert), and certainly should not be able to be recycled to buy more stuff, i.e. add to ones leverage, or offered towards capital requirements. Moreover, if it is indeed symmetric, that would mean if a bank claims to only need to post n dollars in initial margin, then the hedge fund can turn around and use that same number for that same trade, at least up to an understood discount.

As for bankruptcy, we should start with the following. When a margin call is made by one side and it isn’t met, the person making the call:

  • keeps ALL the margin,
  • gets the security, and
  • is a (super-senior level of seniority) claimaint to the variation margin they posted with the counterparty.

Moreover, rules 1 and 2 above do not go into a bankruptcy filing if one occurs (in particular, if the security is a swap, it’s just torn up). This is a key point since that means the bankruptcy is simplified and at the same time the security is back in liquid hands. All over, this setup, or one like it, encourage hedge funds to margin call frequently (banks already do that), which is a good thing, and as described above is a further incentive to invest in liquid, non-complex securities, which in the end creates transparency.

The above idea doesn’t deal directly with desired property 2, and may well cause margins to be lower. One possibility to encourage margins to be of sufficient size would be to allow either party to “put” the security in question on to the other party at a cost of giving up the initial margin posted.

Idea #2: grow a separate system of utility deposit banks

Besides incredibly complicated bankruptcy filings with infinitely many counterparties, one of the major reasons those banks really are too big to fail is that they hold deposits, and the government doesn’t want people to worry that their life savings are at risk, causing a run on the banks and chaos. Another way to get around this, at least eventually, is to create new “utility banks” at the state level which do not trade securities (beyond very basic one like interest rate swaps and treasuries), don’t take large risks, and have FDIC guarantees on savings.

In order to get consumers to switch to banks like this, the government should intentionally create incentives for people to transfer their deposits from “too big to fail” banks to these utility banks. A list of incentives could start with reasonable, transparent fees, and the eventual loss of FDIC insurance guarantee at non-utility banks. Then people who want to stay with risk-taking banks can do so knowing that, as long as bankruptcy laws eventually get simplified, the “too big to fail” guaranteed will in fact be gone.

Moreover, another layer of separation between depositors and utility banks should be the requirement that, even with the restricted kinds of trades allowed for utility banks, they should be done in separate corporate entities (since banks are always a mishmash of many companies anyway).

This idea is not new, and can be seen for example in this article. In fact it is incredibly obvious: admit that what we have now is a guarantee for a get-out-of-jail card for greedy bankers, and transfer that guarantee to a banking system that we’ve created to be boring, along the lines of the post office.

Categories: finance, hedge funds
  1. Aaron
    July 13, 2011 at 11:50 am

    Happy birthday Cathy!


  2. Bindicap
    July 14, 2011 at 1:38 am

    I enjoy your blog a lot, but I disagree with your take on these financial system structural issues.

    Why do you think banks don’t post margin? They certainly do. This is standard with exchanges and in the interdealer market. On a bilateral basis, the banks follow whatever agreements between the parties require, so hedge funds that can’t call for margin probably gave that up for better fees or some other benefit. But lots of bilateral documentation requires margin both ways.

    I’m not sure what you mean by Too Big To Fail here, but your concerns might be addressed by a lot in the Dodd-Frank act, including the new resolution regime for SIFIs. There were quite a lot of failures in the past few years, and many personnel and shareholders don’t feel they got any rescue. Wamu bondholders lost too, though more broadly bondholders did OK in the end, however the ride was rough and they certainly got hurt if they sold during distress. The rule changes already enacted mean you cannot expect bonds to be safe going forward.

    The comment about banks waltzing with more power and fewer checks now doesn’t sound right at all.

    You should follow the rulemaking process if you want to stay on top of what is happening with margin. (CFTC link here, but there should be more.)


    Termination of derivatives on a default event is pretty standard, though one of the DFA changes is you must wait a day before terminating after a SIFI failure, because FDIC will try to sell the whole book intact instead.

    It’s worth noting deposits are generally not at risk from the activities you are concerned with here, because banking rules have long walled of the deposit taking entity from affiliates. We even went through a very stressful period with a lot of bank failures, and the examples where FDIC’s deposit fund took losses were because of traditional credit issues, losses on real estate or securities, or fraud, as far as I know.

    There is a lot of change, and I encourage you to read up on it a lot and try to sort out things before dismissing the significance.


    • July 24, 2011 at 6:39 pm

      Thanks for your thoughtful reply. I’m interested in learning more, and thanks for the overview. Can you tell me though, from your perspective, do you think that Dodd-Frank has effectively removed a “too big to fail” policy? If deposits aren’t a big reason for the original bailout, then what do you think the primary reasons were, and do you think they are still present? Do you think the big banks now feel (or will soon feel) like they are risking their own skin? And do you think my primary goal of motivating transparency could be a result? If not, where do we start disagreeing?

      I’d appreciate your thoughts on this!



      • Bindicap
        August 15, 2011 at 4:00 am

        Thanks for responding. Very sorry for the long delay.

        I do think that Dodd-Frank has done a lot to make the financial system more robust and stable. Several changes address aspects of the TBTF problem, and I do think they are effective.

        * Resolution regime — winding down failing institutions cleanly as possible, the planning process is very helpful even if you have to expect the plans will inevitably need adjustment when tested.

        * Improved Reporting — a lot of the uncertainty from the height of the crisis over chains of exposure will be resolved. I recall this was a huge concern and obstacle in 2008.

        * Increased capital — From Basel rather than DFA. Much is hard to know, but it increases the buffer protecting counterparties, the system generally, and taxpayers.

        * Compensation restrictions — this must not incentivize unwise risks. Should have always been so, but is now explicit and part of oversight.

        There is a lot of opinion about just how effective some of these are and whether certain parameters should be tuned higher or lower, but all together it should have a good effect.

        I think policy in 2008 was directed at keeping the financial system functioning and helping it survive a bank run, or collapse in confidence; so it was primarily an acute liquidity problem and collapse in economic activity. The trigger was in subprime real estate, and it spread from there. There were of course huge actual losses along with all of this, and no doubt a number of undeserving institutions benefited from the government response. We still live with a depressed level of activity and unacceptably poor employment environment in the aftermath, and many balance sheets are too weak.

        I don’t think anything could guarantee some future kind of badness won’t build up in the system and cause another panic, but many of the specific problem that made things worse are much improved by the steps above and others.

        For example, it is not a crazy idea that BOA or Citi might fail and go through resolution at some point if future deterioration requires it. I have even seen some essays suggesting exactly that.

        I don’t think everything has been fixed by any means. For example, a lot of the macroeconomic flows that contributed to systemic imbalances are still largely in place. (Though gradual yuan revaluation is helping.)

        Two issues you bring up that I don’t think were so central are deposits and transparency (but you mean margining?). True and proper deposits were a problem and did motivate things like the unusual guarantees to JPM for acquiring Wamu, but the order of magnitude of deposit issues still seems less to me than the sickness that afflicted shadow banking. Eg, money markets breaking the buck in combination with commercial paper freezing up and repo tightness was probably more significant. (BTW, see this for changes addressing these which seems below the radar http://libertystreeteconomics.newyorkfed.org/2011/07/stablizing-the-tri-party-repo-by-eliminating-the-unwind.html.)

        I just don’t think margining had a lot to do with 2008 and don’t see a big role for special rules or changes going forward.

        Where I suspect we have differences are (1) what type of financial structure should we achieve, and (2) the good faith and effectiveness of various players.

        On point (1), there are a couple models for how things should operate. Take two: (a) large universal entities like we have had, or (b) small, scrappy, focused entities. I know you proposed a further Australian type of model too. There are a lot of problems going from (a) to (b) including an inevitable huge loss of value from an abrupt transition; uncompetitiveness with global banks that would not be forced to restructure; loss of financial services as a US export of sorts. There would be huge opposition to forcing the transition, and regulation of the numerous scrappy entities is unclear (the argument is they would need less, but there are many more). Moreover even if you achieve the transition, you may just see that (b) naturally evolves back into (a) over a decade or several. In fact there were some explicit arguments in favor of forcing this back in 2008 (search Brown-Kaufman) and even in that environment it did not have large support.

        But I think a lot of reform is measured by the yardstick of whether it will achieve the transition to (b) in a stealthy way. And people may be disappointed that it is just possible system (a) can continue.

        On point (2), I have formed a good impression of regulators and even a lot of the lawmaking (more mixed). They are taking things seriously and have achieved a lot. And when you get to banks, I think they do want a system that works and are constructive. Of course they don’t at all support transitioning to system (b) and you have episodes like the credit card changes. But a lot of what you read about evil actors sabotaging things and engaged in various crimes just doesn’t hold up as I see it.

        So that’s my take on where we differ.


  1. July 30, 2011 at 5:48 am
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