PrefBlog

The UK Financial Services Authority has announced that it has published:

Lord Turner’s Review and the supporting FSA Discussion Paper. These take an in-depth look at the causes of the financial crisis and recommend steps that the international community needs to take to enhance regulatory standards, supervisory approaches and international cooperation and coordination.

The Turner Review, as the report is called, starts with a very good review of ‘How did we get here from there?’, with a particular emphasis, of course, on the UK situation. For those interested in the US MMF initiatives, there is the comment:

The development of mutual-fund based maturity transformation was much less important in the UK than in the US: UK consumers do not to a significant extent hold mutual-fund investments as bank deposit substitutes. And while several UK banks set up SIVs and conduits, the scale was in general smaller than those of the big US banks. But US mutual funds and SIVs were very significant buyers of UK securitised credit: when they stopped buying, a large source of funding for UK credit extension disappeared.

There’s an attack on market efficiency … which is explicitly used as an argument for more wise and beneficial official influence of market prices:

• Market efficiency does not imply market rationality.
• Individual rationality does not ensure collective rationality.
• Individual behaviour is not entirely rational.
• Allocative efficiency benefits have limits.
• Empirical evidence illustrates large scale herd effects and market overshoots.

There has been a recent, media-fueled resurgence of interest in financial models and their role in the crisis; the report contains a section on “Misplaced reliance on sophisticated maths”:

Four categories of problem can be distinguished:

• Short observation periods…
• Non-normal distributions…
• Systemic versus idiosyncratic risk….
• Non-independence of future events; distinguishing risk and uncertainty….

I suggest that these problems are not root causes, but symptoms. Believe me, the people who understood the models knew their limits very well. But in any large business, facts are used in the way the famous drunk uses a lamp-post: for support rather than illumination.

I have previously reviewed the problems inherent in estimating Loan Default Correlation. I suggest that the root cause of the problems in this process is the bigness of banks; there are too many layers of management eagerly telling their superiors what they want to hear, rather than making a Career Limiting Move and playing Cassandra. It is for this reason that there should be a surcharge on Risk Weighted Assets for size.

In fact, however, Lord Turner makes an almost sacreligious attack on market discipline – the Third Pillar of Basel II that I have attempted to defend from OSFI’s depredations. Lord Turner claims:

A reasonable conclusion is that market discipline expressed via market prices cannot be expected to play a major role in constraining bank risk taking, and that the primary constraint needs to come from regulation and supervision.

I suggest a more reasonable thing to try is disclosure … not disclosure from the banks, which is currently ignored, but disclosure by portfolio managers. Anybody with a licence to make discretionary trades for clients should be publishing returns – full and complete returns, which should then be published by the regulators (with spot checks for verification, same as with everything else that gets filed). In this way, we can hope to decrease the influence of salesmen in the industry; portfolio management is largely regarded primarily as an unfortunate regulatory cost to be minimized.

For purposes of this review, I’ve only skimmed over the first section. However, there is a section (2.9) of the more meaty sections of the report that brought tears of joy to my eyes:

Several commentators have argued for a clear separation of roles in which:
• Banks which perform classic retail and commercial banking functions, and which enjoy the benefits of retail deposit insurance and access to lender of last resort facilities, would be severely restricted in their ability to conduct risky trading activities.
• Financial institutions which are significantly involved in risky trading activities would be clearly excluded from access to retail deposit insurance and from [Lender of Last Resort] facilities, and would therefore face the market discipline of going bankrupt if they ran into difficulties.
The theoretical clarity of this argument has attracted considerable support.
…
The key tools to achieve [elimination of Too Big To Fail status] will include:
• A regulatory regime for trading book capital (discussed in Sections 2.2 (ii) and (vi)) that combines significantly increased capital requirements with a gross leverage ratio rule which constrains total balance sheet size. Such a regime could include very major variation in capital requirements as between different types of trading activity, effectively achieving a distinction between market making to support customer service and proprietary position taking. The fundamental review of the trading book capital regime, proposed in Section 2.2 (ii), should consider the potential to achieve such distinction.

The Investment Company Institute has announced:

that its Board of Governors has received a report from the Money Market Working Group and has unanimously endorsed the Group’s recommendations concerning new regulatory and oversight standards for money market funds.

John J. Brennan, Chairman of the Money Market Working Group and Chairman of The Vanguard Group, reported to the Board: “The recommendations respond directly to weaknesses in current money market fund regulation, identify additional reforms that will improve the safety and oversight of money market funds, and will position responsible government agencies to oversee the orderly functioning of the money market more effectively.”

The report itself is a miracle of the salesman’s art. Essentially, they propose to eliminate credit risk by regulation:

We also believe that credit ratings, while far from perfect, provide an important floor that constrains money market funds from taking undue risks to increase yield. We therefore recommend that the SEC retain ratings as a starting point for credit analysis.

Finally, we recommend that money market funds designate a minimum of three credit rating agencies that they will monitor for purposes of determining whether a portfolio security may be eligible for purchase. We anticipate that credit rating agencies will compete with one another to achieve this designation, and that this competition will enhance the quality of their analysis and ratings in this market.

I will certainly concede that a lot of the Commercial Paper vs. T-Bill premium is due to liquidity effects. But that does not mean that there is no credit risk.

There is always credit risk. Even beyond market forces, there is always the potential for fraud. Credit Rating Agencies can not, will not and should not be forced to pretend they can determine lack of fraud. Even auditors can’t do that, if the rot exists at a high enough level in a sufficiently complex company. Jesus Christ Himself could give an AAA rating to a security and have it default – remember, he screwed up on Judas.

Portfolio maturity. The maximum weighted average maturity (WAM) of fund portfolios currently permitted by SEC rule may have been too long at some times to accommodate extraordinary market conditions. In response to this observation, most money market funds voluntarily shortened their WAMs, which provided additional protection against interest rate risk. The Working Group believes that the WAM should be shortened from 90 days to 75 days for all such funds. The Working Group also recommends the adoption of a new WAM calculation (referred to in this Report as a “spread WAM”). Unlike the traditional WAM measure that allows funds to use the interest rate reset dates of variable- and floating-rate securities as a measure of their maturity, the new spread WAM requires funds also to calculate a WAM using only a security’s stated (or legal) final maturity date or the date on which the fund may demand payment of principal and interest. This new spread WAM could not exceed 120 days.

I wasn’t aware that US MMFs were permitted to use reset dates in lieu of maturity; the working group’s response demonstrates the intellectual bankruptcy of the typical salesman. We’ve been through two years of the most hellacious credit crunch in memory and people are still referring to pretend-maturities as if they mean something? It’s ludicrous.

Fixed Income is all about credit. The Money Market sector of Fixed Income is all about credit credit credit credit credit. If a portfolio manager – who finds himself virtually ignored in this trash – decides he is no longer comfortable with the credit quality of an issuer he holds, he always has the option of letting it run off the books … unless he was silly enough to buy a 100-year floating-rate note with a quarterly reset. (Such notes have been seen in putative Money Market Funds, by the way. Strange but true.)

I’m not going to get into any big arguments about whether 75 days is better than 90 days. My feeling is that it’s a cosmetic change … but it’s a relatively arbitrary number anyway, so I’m not fussy about it. But the limit on “Spread WAM” should be exactly equal to the limit on WAM.

We recommend that money market funds and other institutional investors in the money market provide the appropriate government body with nonpublic data designed to assist that body in fulfilling its important mission of overseeing the markets as a whole. We pledge to work with appropriate federal officials to implement such a regime for nonpublic reporting and monitoring.

I have quite enough problems already with Regulation FD, thank you very much! The idea that important credit information is to be reviewed not by me, but by a snivel servant clerk with a two-year college certificate in boxtickingology gives me absolutely zero comfort. If it needs to be known, it needs to be public.

The Volcker proposals for MMF reform have been reported on PrefBlog and are addressed in section 8 of the report.

commentators suggest that this would reduce systemic risk by addressing some of the difficulties that money market funds encountered in 2008, as they tried to provide both liquidity and a stable NAV.

The Working Group strongly disagrees. Fundamentally changing the nature of money market funds (and in the process eviscerating a product that has been so successful for both investors and the U.S. money market) goes too far and will create new risks. As discussed below, there are substantial legal, operational, and practical hurdles to redirecting retail and institutional demand from a fixed to a floating NAV product. Indeed, because of the very real and well-ingrained institutional and legal motivations driving the demand for a stable NAV product, investors will continue to seek such a product.

One reason why the product is so successful for the industry is because the stable NAV encourages the unsophisticated to think of an MMF like a bank deposit. It ain’t. There ain’t no capital and there ain’t no federal insurance neither. If a floating NAV forces investors to think about this, so much the better.

These examples demonstrate that despite having floating NAVs, fixed-income funds can experience significant outflows if their investors are highly risk-adverse. The reason is that during periods of financial distress, markets for fixed income securities can become illiquid while the risk-averse investors in these funds are seeking to redeem their shares. As a result, investors’ demands for redemptions can outstrip the ability of fixed income funds—even those with floating NAVs—to meet such redemptions because assets cannot be quickly sold in an illiquid market.

Seems to me, then, that as a matter of prudence a MMF should have a significant allocation in goverments. I have no objection to allowing MMFs to hypothecate some securities, either to the commercial banking system or to the Central Bank (the latter applying a penalty rate) for the week or two that it will take them to mature.

The cost of requiring advisers to hold capital to any meaningful degree ultimately would be borne by fund shareholders or their advisers. To the extent that shareholders bear the costs, they would incur higher fund fees and lower returns. If advisers bear the costs, they may elect to exit the money market fund business and use their expertise to manage large private pools of capital that could serve as money market fund substitutes, or even create offshore subsidiaries to manage U.S. investors’ money, potentially increasing systemic risk.

This totally evades the issue. The fund industry has been getting a free ride due to public perceptions of rock-solid MMFs that have very little basis in fact. This crisis was caused by widespread perception that risk avoidance was free. If it is made plain that risk avoidance is, in fact, not free – that’s a step forward.