Banking

Regulation


Elias BAHRI 42231 Jean-Baptiste COSTA 36374 Tho DAVID DE BEUBLAIN 42307
Paul DEVAUX 42328 Germain MAR 42502 Nicolas MOGARRA 43221


Long-Term Capital Management, L.P

The cost and benefits of Financial Innovation, and the implications of banking regulation.


Since the early 1970s, the financial institutions were continuously looking for new financial
products and services in order to increase their profits, to reduce the risks related to financial
intermediation and to by-pass the existing regulations. Innovations are made to enhance the
allocation of resources through the whole economy and thus to achieve a higher level of productivity
and economic growth.

The main factors that have contributed to the development of financial innovations are the change in
the financial sector and to a greater extent the economic and political situation which prevails in the
country and abroad, the instability of financial markets and the development of computing industries
and telecommunications. A particularity of financial innovations compared with innovations in other
areas is the critical role that regulation of financial activities has in creating new products and services,
new mechanisms, new financial institutions and markets. In other words, Banking Regulation Fosters
Financial Innovation.

Long-Term Capital Management L.P. (LTCM) was a hedge-fund management firm based in Greenwich
(Connecticut) and created in 1994 by John Meriwether, a pioneer in financial innovations. The fund
was combining absolute-return trading strategies and high financial leverage in order to maximize its
profits. LTCM had always a leading position in the financial markets because of the reputation of its
principals and its large initial capital stake ($1 billion of capital).

From this perspective, the rise and fall of LTCM due to speculative bets way too risky jeopardizing the
whole economy to collapse, is a case study when answering the problematic of What are the
regulatory issues related to financial innovations?



Plan:

I. The benefits of financial innovations: LTCMs core strategy.
II. A continued need for banking regulations: The collapse of LTCM.
III. What should be the appropriate regulatory policy in response to
Financial Innovation?

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 I. The benefits of financial innovations: LTCMs core strategy.

i- What are financial innovations and their benefits?

In 1986, the economist Mishkin, in his book The Economics of Money, Banking and Financial
Markets, has grouped the financial innovations in three categories:

1. Financial innovations are responses to changes in demand conditions. Innovations have
been created to reduce the interest rate risk. Indeed, investors wanted to protect themselves
against the increase of the interest rate volatility.

2. Financial innovations as responses to changes in supply conditions. The huge development
of information technology contributed to create profitable financial products and services by
lowering the cost of financial transactions.

3. Financial innovations meant to avoid regulations. Existing banking regulations are reducing
financial institutions profitability. Hence, financial innovations are a way for the financial
institutions to by-pass regulations and so to increase their profits.

Financial innovations are created to improve economic performances by enhancing capitals allocation
efficiency with new ways of financing. The development of new financial products and services allows
investors and issuers to have access to new risk-sharing and hedging opportunities (exchange-traded
options, forwards, futures contracts etc). In this respect, Merton in Financial Innovation and
Economic Performances article is stating that financial innovations improve the quality and the
diversification of banking services enhancing market efficiency.

ii- The use of financial innovations as LTCMs core strategy.

Acting as a pioneer in fixed income arbitrage, John Meriwether chose to make financial
innovations the core strategy of LTCM. Indeed, LTCM was founded to take profit from market pricing
discrepancies and so to outperform the market using complex trading strategies drawn up by its star-
trader.

In order to achieve sustainable high returns and to take advantage of arbitrage opportunities
(misevaluations, market pricing discrepancies etc), LTCMs management established new trading
strategies. In this regard, in September 1997, LTCMs portfolio contained approximately "100 different
strategies and 7,600 positions of all types", of which "6,700 were separate contractual agreements".
With all its strategies, the group succeeded to lower the standard deviation of the portfolio and hence
the risk.

The innovations field of LTCM concerned also "the tax treatment of total return equity swaps" and
the "use of offshore financial centres". With its off-shore limited partnerships structure, LTCM
avoided double taxation. Also, investors were not investing directly in the Fund but they were using a
series of investment vehicles.

In addition, LTCM continuously tried to by-pass existing banking regulation and to take advantage of
it. The trades of LTCM were structured in such a way that they were requiring minimum outlay of
capital. The firm also dedicated many resources to create the most advanced software and financial
modeling technologies possible. As a result of this strategy, LTCM achieved spectacular returns:
annual returns of 42.8% in 1995 and 40.8% in 1996.

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II. A continued need for banking regulations: The collapse of LTCM.

i. LTCM's collapse has called for more banking regulation.

In 1998, the collapse of LTCM could have led to a major crisis without the government
intervention. In that regard, the LTCMs collapse is a perfect example of a too big to fail scenario.

LTCMs investment strategies were based upon hedging against a predictable range of volatility in
foreign currencies and bonds. In 1998, the Russian crisis occurred and that event was beyond the
normal range that LTCM had estimated. Consequently, the Fund was seriously damaged, and by the
end of August 1998, it lost 50 percent of the value of its capital investments. In order to avoid the
collapse of the entire financial system and save the U.S banking system, the American government
was obliged to rescue LTCM: the Federal Reserve Bank of New York President William McDonough
convinced 15 banks to bail out LTCM.

LTCMs collapse comes from 2 major issues: LTCMs position were no longer scalable and the fact that
were was a lack of Banking regulation in regard to new financial products created by LTCM. Indeed,
(1) the Fund was excessively capitalized given the level of risk in the portfolio and the Funds liquidity
needs, and (2) the regulation for Hedge Funds like LTCM was less intense than that applicable to a
commercial bank or broker-dealer in that the Funds faced no capital requirements per se.

Here are a few issues that the Banking Regulation should have tackled to avoid such scenario:

Regulators should have constrained LTCMs excessive leverage. In other words, Regulators
should have promoted the development of more risk-sensitive and prudent approaches to
capital adequacy for Hedge Funds.
Regulators should have made public more frequent and meaningful information on hedge
funds.
Regulators should have enforced Financial institutions to enhance their practices for
counterparty risk management and encourage improvements in the risk-management
systems of Hedge Funds and similar financial institutions.
Regulators should have considered stronger incentives to encourage offshore financial
centers to comply with international standards.

ii. The financial crisis of 2007-08: a wakeup call for banking regulation.

Ten years after the LTCM's crisis, a major financial crisis broke out in 2007, which would lead
to an economic crisis. Financial innovation had also its responsibilities in this crisis. The 2007 crisis,
also known as the subprime mortgage crisis began with the huge decline in home prices after the
house bubble broke. This bubble was possible thanks to new finance practices like securization (with
CDO and MBS) and to new kind of swaps like CDS.

Securization had appeared in 1960 but it really began to expand in 2000. Securization means pooling
different kind of contractual debt (mortgages) and to sell their related cash flows to third partiy
investors as securities. Thanks to securization, banks were able to provide real estate sector with huge
amount of debts without supporting the risks of default. As banks felt safer, they lent more and more
to decreasingly solvable economic agents. This led to a huge development of securitized assets, which

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also became far riskier than they seemed to be. For investors, securization was a way to have safe
investment products with high returns.

However, securization was complex and it limited investors' ability to measure the risk of these
products. How were the investors able to measure the default risk of all the credits in the securitized
asset and to measure the possibility that all credits default at the same time? It brought a lot of
opacity. For instance, Lehman Brother was so deeply involved in the securitized market that it had
become a real estate company without people noticed it. Like LTCM, it gained a huge amount of
money during the bubble but a 3-4% decline in the value of its assets was enough to make it go
bankrupt. That happened in 2008.

So, at the beginning of 2000, financial innovations were used to decrease risk and to increase return
on investments. However, financial institutions used those innovations to take large positions. As
those innovations were complex, financial institutions were not able to monitor the risks that they
were taking. Regulators and credit agencies also failed to regulate and to monitor the risks of those
financial innovations.

To conclude, it is obvious that financial innovations can bring lot of instability to the financial
system: the two-financial crises are evidence of that. We can regret that regulators and government
leader did not learn from the 1998 crisis and that it took a second huge crisis to understand the need
of a worldwide regulation which will appears with Basel III.

III. What should be the appropriate policy response to Financial
Innovation?

i- Regulation as a driver of financial innovation.

The main goals of banking regulation are to promote markets that are fair, clean, orderly and
efficient, to ensure that retail customers and other end-users of financial services are protected.
By seeking to improve the economic performance of the financial system, the regulators can enhance
the competition and ensure the market integrity. Government's action can affect the market in
multiple ways. First, it can operate as a simple market participant when it completes an open-market
operation, through that, it has to follow the same rules as any other actors. Second, government
sometimes supports the development or even creates new financial products or markets such as
securitized mortgages, index-linked bonds or all-savers accounts.

New regulations such as Basel 3 intends to strengthen the safety links between the banks and the
market in order to improve their abilities to withstand stresses and shocks. In order to achieve that,
banks have to increase both the quantity and the quality of their capital. To realize that, they have to
reorganize the strategy of the bank around the retail to be able to collect more deposit.

Due to the capital constraints required by Basel 3, banks had been less able to provide funds to
companies through the financial intermediation market. Thus, investment banks have started to help
companies to raise fund on open market. It has improved efficiency of the market by lowering
transactions costs and reducing agencies costs.

The constraints of regulation including taxes and accounting conventions is a driving force behind
financial innovations. According to Merton Miller, frequent and unanticipated changes in regulatory
and tax codes have driven most of financial innovation over the two last decades.

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 ii- The need for a global and efficient banking regulation.

Since 2007 and the subprime crisis, the banking regulation had to adapt to the financial
innovation in order to ensure more stability and reestablish investors trust in financial markets. The
financial excess that led to the subprime crisis forced banking regulation to innovate and to
implement stricter rules in the banking industry. As a response to the subprime crisis the Dodd
Frank Wall Street Reform and Consumer Protection Act was signed by President Obama in June
2010. The Dodd-Franck Act implemented a series of new government agencies that should oversee
the banking industry. Among which the Financial Stability Oversight Council that monitors the
financial stability of financial institutions considered as too big to fail (companies whose unique
failure could have a negative impact on the overall economic system). The Liquidation Authority has
the power to break up those banks who represent a huge systemic risk. Another key measure of the
Dodd-Franck Act is the Volcker Rule which separates the investment function from the commercial
functions of banks also established stricter rules for banks to invest. Indeed, the Volcker rule forbid
proprietary trading (the division in which the bank invests its own money which exposed them the
most) and limited speculative trading. The Dodd-Franck acts also restricted trading of derivatives
such as CDS, the key financial innovation that led to the subprime crisis.

A global response to the 2007 financial crisis has been the implementation of Basel III. Basel III is a
global framework intended to strengthen bank capital requirements through the increase of banks
liquidity and the decrease of banks leverage. The capital requirement is ensured by the Common
Equity Tier 1 ratio that every bank should maintain above 4.5% at all time. Basel III implemented 2
liquidity ratios to increase banks liquidity: the LCR and the Net Stable Funding Ratio. Finally, banks are
now expected to maintain a leverage ratio above 3% under Basel III.



To conclude, even if banking regulation has adapted itself since 2007 mainly through the
Dodd-Franck Act in the US and Basel III worldwide, it remains very difficult for the banking regulation
system to regulate the banking industry on such a large scale. Political and economic competition
between countries slowdown the banking regulation and the banking industry always find new way
to avoid regulation notably through the OTC market. Also, the banking regulation is considered by
many economists as a burden to profitability. By limiting the risk exposure of the banking industry,
banking regulation creates a lack of investors on high yield investments that can be a source of
economic growth.