Taming banks' wild beast

Writers of short stories are not always good at spinning a longer yarn. I was worried that Alfred Steinherr might just have taken an award-winning essay from 1994 and stretched the argument out very thinly to fill this book. Fortunately, I was wrong. The style is direct and entertaining, and the reader is carried along by the arguments.

The theme is that derivatives - futures, options, swaps and such - make the traditional regulation of banks almost impossible. The regulator cannot inspect a bank once every six months and hope to understand the risks that it is taking because derivatives allow the exposures to be swapped from one form to another overnight. For example, if bond exposures are regulated less severely than equity exposures, the bank may take a bond exposure and then swap it into an equity exposure. The regulatory system may try to take this into account, but the bank has an incentive to look for the best possible mixture of exposures.

Non-financial companies try to do the same when they present their accounts, but they have less flexibility than banks, whose balance sheets consist almost entirely of paper assets and liabilities.

Steinherr argues that banks should not be regulated as whole entities, but according to their individual activities. He calls this functional regulation, as compared with the current institutional regulation.

The starting point would be a clear demarcation between deposit taking and other functions. Derivatives would be regulated by inducing banks to shift from using off-exchange (over-the-counter) contracts, which are opaque, to using on-exchange contracts, which have public prices and margining to remove the credit risk. For example, instead of holding a swap on its own balance sheet, a bank would register it with a clearing house and pay margin daily as the swap changed in value.

What is happening here is a kind of privatisation of regulation. Instead of having to keep to rules set by the regulator (such at the UK's Financial Services Authority or the US Federal Reserve), the bank keeps the rules set by the clearing house. Both styles of regulation demand that enough capital is available to cover market risk, but the clearing-house takes over the credit risk as well.

I wish that Steinherr were right, but there are doubts. What he advocates is, in effect, self-regulation within a set of rules set by a governmental regulator. In the United Kingdom, the recent trend has been in the opposite direction, towards more central regulation. Banks do not seem very interested in laying off their credit risks with a clearing house, presumably because risk-bearing is profitable.

Since this book was written, the largest derivatives "disaster" has been that of the hedge fund, LTCM (Long Term Capital Management), in September 1998. The many banks with which LTCM dealt were margining the positions, and LTCM collapsed when the margin could no longer be paid. The New York Federal Reserve had to broker a rescue plan to avoid the risk of a general financial disruption. The problem, from a regulatory viewpoint, was that nobody was aware of the total size of the LTCM exposure.

Margining was not the problem, but rather the old case of unwise lending on a large scale. Nevertheless, if centralised margining had revealed the size of the position, the amount of lending might have been reduced.

Steinherr's book is divided into four parts, with the first two analysing the status quo and the next two covering public policy and the future. The book describes how the financial system evolved, why risk management is central to intermediation and why banks are likely to be subsumed into more general financial conglomerates.

There is also a discussion of what went wrong in some well-known derivatives disasters, such as Barings Bank, Metall-gesellschaft and Orange County.

Each chapter starts with a "novelette", which raises the key issues in an entertaining way. As an example of the style, try this: "Today's OTC (off-exchange) markets have developed with very little infrastructure and resemble air traffic in unregulated sky. Hence concerns about accidents."

The book is a stimulating read with an excellent overview of risk in banking. It can be recommended to anyone who is interested in banking, derivatives and the regulation of the financial sector.

Gordon Gemmill is professor of finance, City University Business School, London.