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New Rules May Prevent Banks From Blowing Themselves Up For Cheap

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If you're in a certain line of work, and I bet you are, then your main concern about things like the Volcker Rule and increased capital requirements for banks is that they might reduce your comp. If you're in that line of work, you're also probably the sort of person who has a higher than average aversion to having your comp reduced. However, you're also the sort of person whose comp everyone else would be happy to see reduced, because you make too much already you greedy jackass.

That poses a quandary because nobody's all that interested in hearing your arguments against the new rules, even if they're good arguments and not 100% about your own personal remuneration. One thing you could do is get proxies to make your arguments. If you think that the Volcker Rule will reduce liquidity in foreign government bonds, you could suggest to foreign governments that it's really important that they lobby against the rule on your behalf. You did that. Good work. Let's see how it turns out. If it turns out well, the next step would be to get other clients to say "well, we want liquidity in our [stocks /bonds/rate swaps/whatevers] too," since that would then be a more compelling argument.

I think that's what's going on in this sort of amazing FT article, but something has gone terribly wrong:

The cost of “tail hedging” has retreated from last year’s peak, when anxiety over the eurozone was at its highest, yet premiums remain elevated and investors are worried they could soon climb again.

The fear is that higher capital requirements for banks and the proposed Volcker Rule, which would prohibit banks from engaging in proprietary trading, will limit the ability of Wall Street dealers to support protection against risk and reduce liquidity in products such as variance swaps. ...

Dealers warn that if the cost of capital for underwriting tail risk hedges is too high when proposed rules are finalised, they will have little choice but to step aside, raising costs for institutional investors managing funds on behalf of smaller clients.

“When the next tail event occurs, pension funds and insurers will get hit hard as they have been unable to hedge that risk,” says [MIT finance prof Andrew] Lo. “This ultimately affects the consumer via the pension and insurance industries, who can’t use these instruments to hedge long-term risks.”

Oh noes but what? I'm sure I'm missing something here but where I come from:
(1) The best possible bearers of the sort of risk represented by things like ten-year S&P puts and variance swaps are pensions and insurance companies with giant pots of money and actuarially predictable liabilities that pay out over decades.
(2) Hedge funds are probably fine too, since they tend to have rich patient money.
(3) Possibly the worst bearers of that risk are investment banks funded by overnight repo.
(4) I mean, really! "Tail risk" like, definitionally, means "risk of the sort of environment where some investment banks stop existing." What is the point of investment banks selling "tail risk" insurance? I've got your Lehman Brothers 10-year S&P puts right here.

The approach is sort of baffling but I think there are real arguments buried here. Apparently going long vol is a thing that investors are into, and there are new ETFs popping up to let them do it. More generally, making markets in volatility probably is a socially useful function for Wall Street dealers, since customers do have legitimate reasons for wanting to buy and sell volatility, and since dealers tend to be more able than their customers to replicate options by trading in the underlier.

I think that, anyway - but I suspect many others don't, since "buying and selling volatility" doesn't exactly sound socially beneficial. So as a PR strategy leading with "but where will our derivatives go?" seems off-base. And leading with "but where will our tail risk derivatives go if we can't buy them dirt cheap from undercapitalized banks?" seems really, really crazy. If banks really are scaring their pension fund customers into going public with their concerns that they can't buy enough long-dated out-of-the-money puts from dealers because of new capital rules - they should stop.

On the other hand, if I were a hedge fund looking to pick up some business selling variance swaps - where "the bid and offer is very wide, and when you want to monetise there is no market," I'd be pretty psyched to see a story like this confirming everyone's worst fears about investment banks taking risky gambles with investor money. I'd be particularly happy to see that, "While some say that hedge funds and other investors may fill the void left by dealers, the worry is these new entrants would not arrive until the cost of hedging had risen further." Getting rid of the competition is a good start on that goal.

Cost of ‘tail risk’ protection to soar [FT]
Tail-Risk Hedges on Volatility Lure Money Even After Stocks’ January Surge [Bloomberg]


The Volcker Rule Will Come Too Late For Kaufman Bros.

If you're a more or less regular consumer of efficient markets hypothesis Kool-Aid then a fun activity is to handicap the probability of various public policy things based on market reaction.* So for instance Obama's budget is going to reduce the tax deductibility of munis! And the muni market didn't care! So, no, Obama is not going to reduce the tax deductibility of munis. You heard it here first, or last, or whatever. (Exercise for the reader: is Obama going to raise the tax rate on dividends?) Since today seems to be Volcker Day hangover it's worth pondering this: