Derivatives and Capital Requirements

I really enjoyed Jesse Eisinger and Frank Partnoy's Atlantic piece "What's Inside America's Banks?" The article makes the case that both banks, and the regulatory apparatus in which they operate, are astonishingly complex. As an example, they read Wells Fargo's annual report, which is a maze of confusing language and obfuscates more than it enlightens.

Eisinger and Partnoy argue that simpler regulations based on materiality standards would suffice. Regulation should be as simple as the CEO of a company certifying that they have disclosed material information to their shareholders. Prosecutors would be free to bring criminal charges against CEO's who didn't do their due diligence in this regard. The problem, they say, with complex regulations is that it allows lawyered-up companies to meet the letter of the law without actually providing transparency.

I think they make a good case. But seeing as we live in a world of complex regulations, one thing struck me as important:

Like other banks, Wells Fargo uses a three-level hierarchy to report the fair value of its securities. Level 1 includes securities traded in active, public markets; it isn’t too scary. At Level 1, fair value simply means the reported price of a security. If Wells Fargo owned a stock or bond traded on the New York Stock Exchange, fair value would be the closing price each day.

Level 2 is more worrisome. It includes some shadier characters, such as derivatives and mortgage-backed securities. There are no active, public markets for these investments—they are bought and sold privately, if at all, and are not listed on exchanges—so Wells Fargo uses other methods to figure out fair value, including what it calls “model-based valuation techniques, such as matrix pricing.” At Level 2, fair value is what accountants would charitably describe as an “estimate,” based on statistical computer models and what they call “observable” inputs, such as the prices of similar assets or other market data. At Level 2, fair value is more like an educated guess.

Many banks’ stocks are below “book value” today. This indicates that investors don’t believe the stated value of the assets on banks’ books, or don’t believe banks will be profitable in the future—or both. 

Level 3 is hair-raising. The bank’s Level 3 estimates are “generated primarily from model-based techniques that use significant assumptions not observable in the market.” In other words, not only are there no data about the prices at which these types of assets have recently traded, but there are no observable data to inform the assumptions one might use to generate prices. Level 3 contains the most-esoteric financial instruments—including the credit-default swaps and synthetic collateralized debt obligations that became so popular and prevalent at the height of the housing boom, filling the balance sheets of Bear Stearns, Merrill Lynch, Citigroup, and many other banks.

Regulation should account for the fact that the pricing of Level 2 and Level 3 assets is imprecise and has a greater margin of error than Level 1. To compensate for this, Level 2 and Level 3 assets should require greater capital ratios as a security. This will do two things: First, the higher capital ratios will provide safety in case the assets were overvalued. Second, it will push banks to do more of their business in securities that are traded on public markets. Currently banks are incentivized to deal in over-the-counter, boutique securities because they can charge higher prices to their customers for these unique assets.

In a sense, the "problem" with derivatives isn't that they exist, rather they are too complex for shareholders to determine if they are being priced accurately. Creating incentives to reduce the number of assets banks are holding for which there is no public market would add transparency.