Regulation, Risk and Profit
• In times of financial crisis and monetary
losses, it is often said that social science
can not be as precise as science.
• We will look at an example of science
• If you climb up a play set, you may find
signs like “Maximum capacity: 150 lbs”.
• Does that mean if you are 151 lbs, the
play set will collapse?
• The play set can support at least 500 lbs,
several times the capacity requirement.
• Engineering projects usually have large
margin of safety.
• When an engineer estimates the weights which
a bridge or beam must support, or the pressures
to which a boiler will be subjected, he does not
provide merely for those stresses in building the
structure. The engineer multiplies his estimates
by three, six or even by twenty, in order to make
the structure thoroughly reliable. The greater
strength of the material, above that calculated as
necessary, measures what is known as a “factor
of safety.”( Cannon, 1932, p. 231)
• In financial institutions, capital adequacy
ratios based on tier 1 capital (equity) may
be 4%; capital adequacy ratios based on
tier 1 and 2 capital (equity + long term
debt) may be 8%.
• Will most financial institutions provide 16%
capital adequacy ratio, doubling the
minimum requirement?
• The above examples show that social
sciences and science do not differ as
much in their precision as in their
treatment of factor of safety.
Why the differences?
• If a company tries to save materials from play
sets or bridges, they could get at most millions of
extra profit.
• If a play set or a bridge collapsed and some
people got injured or dead, probably the
company will get out of business and managers
will get into prison.
• If a bank lowers its factor of safety, it can make
billions of extra profits.
• If a bank faces collapse, it is often bailed out by
the government and no one is charged even
when there are multibillion losses.
• If the society demand bank operations as
safe as engineering projects, bankers
probably can earn only as much as
engineers. The income from a profession
is largely determined by social attitudes.
The evolution of regulatory
processes
• Regulations are often initiated to stabilize
financial systems or to protect the general
public. However, they often evolve to
serve the interest of the financial
institutions, the very targets of regulations.
Example
• Deposit insurance
• Original purpose
– Protect unsophisticated small depositors
• Evolved function
– Protect sophisticated large market players
– Bail out large financial institutions engaging in
highly leveraged businesses
• We will discuss how VaR (Value at risk)
was evolved from a risk management tool
into a profit generating tool for financial
institutions. Gradually the measurement of
VaR becomes the mask of the true risk of
the portfolios.
VaR (Value at Risk)
• History and rationale of VaR
• Definition of VaR of a portfolio
• The threshold value that the loss on the portfolio
over the given time horizon exceeds this value in
the given probability level.
• For example, if a portfolio of assets has a oneyear 5% VaR of $100 million, there is a 0.05
probability that the portfolio will fall in value by
more than $100 million over a one year period
VaR to compute regulatory capital
• A bank has 100 million dollar capital. On
average, bank asset will have 80% probability to
generate return of 0.125 and 20% probability to
generate return of -0.4 over one year period.
What is the return on asset of the bank? What is
the one year 5% VaR of 1 million dollar asset? If
the regulatory system requires one year 5% VaR
to be equal or less than a bank’s capital, how
much asset can the bank hold? What is the
return on capital with this level of asset? What is
the largest amount of loss the bank will incur
with this level of asset?
Continued from the last question
• There are two banks with identical capital and earning
structures as described in the last exercise. Suppose the
earnings of the two banks are independent. Two banks
sign an agreement. In a particular year, if one bank
earns positive return and another bank makes a loss, the
two banks will equalize their earnings. With this
agreement, what is the one year 5% VaR of 1 million
dollar asset for each bank? If the regulatory system
requires one year 5% VaR to be equal or less than a
bank’s capital, how much asset can each bank take?
What is the return on capital with this level of asset?
What is the largest amount of loss each bank will incur
with this level of asset?
A further refinement
• There are two banks with identical capital and earning
structures as described in the last exercise. Suppose the
earnings of the two banks are independent. Two banks
sign an agreement. In a particular year, if both banks
earn positive return, they will set aside half of their
earning to be distributed in years when one bank earns
positive return and another bank makes a loss; if one
bank earns positive return and another bank makes a
loss, the two banks will equalize their earnings. With this
agreement, what is the one year 5% VaR of 1 million
dollar asset for each bank? If the regulatory system
requires one year 5% VaR to be equal or less than a
bank’s capital, how much asset can each bank take?
What is the return on capital with this level of asset?
What is the largest amount of loss each bank will incur
with this level of asset?
Actual operation
• Instead of signing agreements between
two banks, different banks will sign Credit
Default Swap contracts with a large bank
or insurance company.
• In the last financial crisis, AIG signed
many CDS with different banks.
• AIG was the financial institutions that
received most bail out funds
Example
• A bank has 100 million dollar capital. On average, bank
asset will have 80% probability to generate return of
0.125 and 20% probability to generate return of -0.4 over
one year period. The bank signs an CDS with an
insurance company. When the bank makes a loss, the
insurance company will make full payment of the amount
of loss. The insurance company requires 10% of profit
margin over its expected payment.
• What is the insurance premium? What is
one year 5% VaR of 1 million dollar asset
for the bank after signing this CDS? If the
regulatory system requires one year 5%
VaR to be equal or less than a bank’s
capital, how much asset can the bank
hold? What is the return on capital with
this level of asset? What is the largest
amount of loss the bank will incur with this
level of asset?
Solution
• The expected payment in a year is over one
million dollar asset is
• 0.4*20% = 0.08 million dollar
• After 10% profit margin, the premium is
• 0.08*1.1 = 0.088 million dollar
• With this payment, there is 80% probability, an
asset will earn an return of
• 0.125-0.088 = 0.037
• there is 20% probability, an asset will earn an
return of
• -0.088
• The expected rate of return on asset is
• 0.037*80% -0.088*20% = 1.2%
• one year 5% VaR of 1 million dollar asset
• 0.088 million dollar
• The amount of asset the bank can hold is
• 1/0.088*100 = 1136.36 millions
•
•
•
•
The return on capital is
1.2%*1136.36/100 = 13.6%
This is higher than 5% without CDS.
With further refinement, the return on
capital will be higher.
Games between regulators and
market players
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Purpose of Regulation
To make the financial market stable
Purpose of market players
To obtain high return on equity
Investment strategies evolve with
regulatory systems
The health of individual and the
health of the system
• In life, no system lives on forever. Instead,
new life replace old life.
• In financial system, easing the restriction
to grow new financial institutions so
youthful and energetic new banks can
provide better service to the public.
• The health of individual institutions is not
equivalent to the health of financial
system.
Infection and immune systems
• Immune systems attempt destroy invading
microbes
• Microbes change to evade attacks from immune
systems
• “prefect market” is never achieved inside human
body. Immune systems always change to
respond to outside changes. Similarly, optimal
regulation never exists. Operators’ activities will
change according to regulations.
• Clever invaders often have similar
structures of cells of host.
• Similar, the best way to rob a bank is to
own a bank.
• William Black: The Best Way to Rob a
Bank Is to Own One: How Corporate
Executives and Politicians Looted the S&L
Industry, 2005
Parallel between pollution and risk
• The solution to pollution is dilution
– In chemical industry
• The solution to risk is dilution
– In financial industry
• Securitization of loans
– Mortgage backed securities
– Credit card and other payment backed
securities
• Parallels in results
General Discussion
• From the mainstream economic theory,
unregulated free markets are usually optimal.
Regulation is warranted only when the market is
imperfect.
• However, all organisms and organizations
regulate their internal environments. Many also
regulate their external environments.
• In general, “higher” organisms and organizations
regulate their internal environment more
precisely with higher resource expenditure than
“lower” organisms and organizations.
On perfectness
• This situation is analogous to the state of biology
before Darwin. According to Robert Trivers, “In
the old system, each species was imagined to
have been created according to some ideal type.
Variation was just so much noise superimposed
on the ideal type. After Darwin, the variation
itself was seen as real and important, while the
notion of an ideal type was recognized as a
useless abstraction.” (1985, p. 22)
Mammals and Grasses
• Grasses first appeared on the earth about sixty
million years ago, around the time when dinosaurs
went extinct. The extinction of dinosaurs provided
mammals with wide open ecological niches and
mammals multiplied rapidly. Mammals, as warm
blooded animals, have much higher metabolic rates
than cold blood animals. Fast growing grasses can
provide more energy than trees. Hence the spread
of grasses will benefit mammals. Since mammals
are more active than reptiles, they disturb the
landscape more, which makes the environment
more hospitable to fast growing grasses than slow
growing trees.
• In the past sixty million years, grasses
have spread very fast and now are
covering approximately 20% of the earth’s
land surface (Kellogg, 2001). If our
speculation is true, then mammals have
played an active role in regulating the
environment to benefit the spread of
grasses, which in turn benefits the spread
of mammals.
Humans and grasses
• All food crops, such as wheat, rice, corn,
are grasses
• All vegetables are grasses.
• Human beings actively clear forests.
• We contribute to the spreading of grasses.
We continue a trend that has lasted for
more than sixty million years.