Banking regulation meets law of unintended consequences

By Laura Noonan

LONDON (Reuters) - Arcane measures designed to make banks safer are pushing trading activity into areas where the banking regulator's writ doesn't run, making conventional markets more risky as volumes dwindle.

Regulators determined to avoid a repeat of the financial crisis that floored investment banks in 2008 and beyond introduced a rule at the beginning of last year that makes banks hold enough capital to cover the worst 12 months in the history of their trading portfolio, on top of a capital provision to cover recent asset volatility.

This "Stressed Value at Risk" (VaR) rule and other measures such as a risk charge that makes it harder for banks to hold lower-rated credit assets have tripled the amount of capital global banks have to hold against their trading books, according to Jouni Aaltonen, director of prudential regulation at European financial industry group AFME.

The knock-on effects are widespread and not always intended.

Bankers say the post-crisis regulation has forced them to trade less, sucking liquidity out of the market and making buying and selling assets more expensive for everyone, from pension funds to corporates.

"The regulators, as well as the banks, don't necessarily have a full grasp of the impact of these types of things yet, and won't have for some time," said one senior executive at a major investment bank, who said there had been "pretty big" repercussions in some markets already.

Mark Denny, head of global markets dealing at Investec Asset Management, said the fall in liquidity had increased the bid/ask spreads for large fixed-income and index trades, making trading more expensive.

"This has resulted, from our perspective, (in our) being very cognizant of the increased trading costs within our business and exploring liquidity pools across asset classes," he added.

Investors can seek out pools of liquidity on alternative trading venues and platforms that buy or sell direct without the help of a dealer. That effectively takes the business into the shadow banking sector, over which banking regulators have no purview.

One European supervisor, who asked not to be named, agreed that the regulations had "unexpectedly compressed the liquidity of important markets with the related consequences".

The Basel Committee of Banking Supervision, which is responsible for drawing up these and other global banking rules, did not respond to requests for comment.

A review into the rules is in its early stages, and new measures won't come into place until 2015 at the earliest, and probably later, so markets must live with Stressed VaR for now.

BLACK-LISTED ASSETS

As well as the higher total capital levels demanded by Stressed VaR, the rules also lead to biases against certain assets, said David Soanes, head of financial institutions at UBS.

The European supervisor said once-troubled assets such as the debt of U.S. financials, which plummeted after the 2008 collapse of the Lehman Brothers investment bank, were an example of those that could effectively be "blacklisted".

"The extreme volatility experienced ... will forever affect the risk content of debt issuances of the concerned firms, irrespective of the fact that in the meantime they have materially strengthened their balance sheets to the point that in some cases they are actually different animals," he said.

That appears to be contributing to a fall in the size of trading books.

Data compiled by investment banking consultancy Tricumen shows the Stressed VaR figures for European investment banks fell sharply from year end 2011 to estimates for the end of 2013.

"The reduction is because smart banks have been looking to trim their businesses (and hence trading books) to reduce the impact of measures like stressed VaR," said Tricumen's Seb Walker.

Some think that's no bad thing.

"Inevitably it's going to have impact - it was intended to have impact," said a senior banker at a second investment bank. "The fact that dealers are holding less inventory is not only predictable, it's desirable."

But as more banks curtail their activities, increasing market volatility, that also raises the capital banks must set aside for Management VaR, which is based on recent volatility and is assessed on top of Stressed VaR. So as banks leave the market, the costs go up for the remaining players.

"You can argue that collectively it's suicide, but individually it makes sense," said UBS's Soanes. "These are mechanical rules; there's nothing dealers can do except put more capital into their business, but that's not what banks are doing."

They are cutting back on business instead.

"The reality is the world is riskier," said Roger Lister, chief credit officer at ratings agency DBRS. "Management is giving them (traders) less room to hold inventory, and there's less inventory around, so prices are more volatile, which means that risk managers are more worried," he said.

"It's probably exaggerating to say that there is a death spiral, but there is this recognition that volatility is going to be greater and liquidity is going to reduce."

(Additional reporting by Simon Jessop in and Clara Denina in London Reporting By Laura Noonan; Editing by Will Waterman)