A simple remedy for a Wall Street danger

A local newspaper has this column, A simple remedy for a Wall Street danger, behind a pay firewall. The article is by

James M. Stone, former chairman of the Commodity Futures Trading Commission and commissioner of insurance for Massachusetts, is CEO of the Plymouth Rock group of property and casualty insurance companies.

It should be safe to assume that James M. Stone knows what he is talking about, at least until proven otherwise.

A few quotes from the article ought to be enough to boggle your mind.

All three of the largest US banks have open derivatives positions in excess of 24,000 percent of their equity capital. Neither models nor markets can protect them from small percentage imbalances. In addition, bank trading relationships around the world are so interconnected that if one goes down all are threatened. No CEO or board of directors, however talented and honorable, can oversee trading at the multi-trillion dollar scale with perspective and precision enough to assure the avoidance of systemic impairment. Nor can any government oversight body.
Bank lobbyists insist that all this trading is needed to facilitate commercial transactions, but don’t be fooled. The open derivatives positions at the three largest US banks exceed twice the GNP of the world. Add in large European and Asian banks, and the commercial hedging argument becomes a parody.
Under present rules, banks are free to put us all at risk in derivatives trading without creating any offsetting cushion. Every derivatives transaction involves some basis risk (that two paired commodities will not continue to move in unison), some counterparty risk (that the trade will not honored by the other party), and some human error risk. Accountants and regulators know well that netting massive positions to zero cannot reflect true exposure.

Among other people who understand the problems of “netting massive positions to zero” are mathematicians, computer scientists, chemist, physicists, and engineers.  Let me see if I can present an example to people who might not get the implications of what Stone is saying.

Supposing that a bank’s $75 trillion in derivatives positions consist of $37,501,000,000,000 on one side of a transaction and $37,502,000,000,000 counterbalancing position.  The unbalance between these two positions is 0.003%.  That would be an amazing accuracy to achieve in any human endeavor.  The only issue is that the approximately 0.003% imbalance amounts to $1 billion dollars.

So you say, $1 billion is a lot of money, but it is small potatoes compare to $75 trillion.  Taking Stone’s figure of derivatives positions of over 24,000 percent of equity capital gives a figure of about $312 billion of equity capital.  That still seems pretty big compared to a $1 billion loss.  However, $312 billion equity capital is only 0.4% of the derivatives positions.  If there were a mistake of 0.4% in the balance of the positions that turns out to be a realized loss, then the bank’s equity capital is wiped out.

Leverage is a wonderful money making tool if it doesn’t turn against you.  Also compare the $75 trillion of private leverage to the $14 trillion in government debt that has the Republicans so concerned.

So let me cut to the chase and give you Stone’s proposed solution:

Whenever a new position is taken, there should be a mandatory accompanying reserve or capital charge. This would have a two-fold benefit. It would increase protection for both the public and the banks and it would dull the appeal of hazardously oversized trading accounts. Although regulators should set the actual amounts, imagine that the charge was uniformly 0.1 percent of the notional position value. Open positions of $75 trillion in derivatives would require $75 billion put aside, an amount large enough to make that trading scale unappealing. Charges to match the risk created would bring trading volumes back to sensible size with a minimum of new regulations and no need to outlaw useful commercial practices. They would simply acknowledge that all derivatives positions, however useful, impose some risk on the holders and the public. Current scale imposes an unmanageable risk.

It is a shame that this article is behind a pay firewall meaning that more people will not get to read the article.

July 5, 2012

RichardH has discovered that the article has emerged from behind the paywall. A simple remedy for a Wall Street danger appeared in The Boston Globe.

Leave a comment

This site uses Akismet to reduce spam. Learn how your comment data is processed.