The use of leverage in financial markets: regulatory issues and possible responses

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1 Discussion Paper 2 The use of leverage in financial markets: regulatory issues and possible responses 1. Introduction 1.1. Recent events have focused attention on the use of leverage in speculative trading activity and have served to remind regulators that a combination of risky strategies with enormous leverage is not uncommon in many parts of the finance industry. For example both investment banks and hedge funds pursue leverage-based strategies Leverage for the purpose of trading in financial instruments is generally achieved by borrowing in order to fund speculative positions, and by using OTC derivative instruments and other off-balance-sheet items to increase the risk-exposure and hence the potential rewards of its trading positions. It is thought to be relatively straightforward, inexpensive and, hence, widespread. Reports suggest that investment banks, for example, routinely have leverage in excess of 20 to 1. 1 In the case of Long Term Capital Management, the firm was reportedly leveraged to about 1,300 times its capital Concerns have been raised that lenders are extending enormous amounts of credit to market participants without collecting sufficient or appropriate collateral, and without due consideration of counterparty risks. Concerns have also been raised about the extensive use of OTC derivative instruments to amplify risks, and to facilitate complex speculative positions, in an opaque manner Thus the broad issue appears to be that excessive leverage can be achieved through over-borrowing and the use of OTC instruments and off-balance-sheet items. Specific issues include poor credit-management on the part of lenders, the ease of securing credit by borrowers and the opacity in which leverage through financial markets is conducted As recent events and regulatory responses have shown, these issues are of very real concern to both securities and banking regulators. They have significant consequences on market integrity as well as on systemic stability. This note presents a discussion of these issues and offers some ideas for possible responses. Section 2 briefly examines the issues described above, while section 3 concludes by drawing some implications for the way regulation might proceed. 1 The risk business. The Economist. November 14th 1998.

2 2. Major issues Major issues in the use of leverage relate to credit management by lenders and the use by market participants of relatively unregulated over-the-counter instruments and off-balance-sheet items for leveraging market positions. In both areas, issues arise as a result of insufficient disclosure either to the market or to the authorities Credit management Recent attention has focused on the fact that even large banking systems are not immune to problems of poor risk management: Large exposures German banks are reported to have had an aggregate exposure to Russia of about US$31b at the end of 1997, while French banks, which had already succumbed to the bursting of a property bubble a decade earlier, were exposed to at least three East Asian countries to the tune of nearly US$20b. In many cases, these exposures were reported to be either not hedged or poorly collateralised. Operational controls In the case of Long Term Capital Management, one bank had apparently ignored its own internal policy. Reports suggested that for the sake of generating business, the bank went ahead with extending credit to the fund despite concerns over the counterparty risks involved. Credit assessment Concerns have been raised that competitive pressures are encouraging lenders to continue extending credit without verifying key information, such as the number and identity of their other counterparties, the nature and extent of their speculative positions sometimes even company fundamentals. In the United States, banking authorities have warned of the spread of ugly loans that are extended despite the existence of fundamental structural weaknesses in the borrower In some cases, lenders have had difficulty in determining the credit risk of certain counterparties, of whom very little or at least not enough is known. For various reasons, certain market participants are subject to less disclosure requirements than others. Private investment partnerships in some onshore jurisdictions, for example, bear a considerably lighter regulatory burden in this respect than those whose shares are available to the public. Moreover, certain borrowers, such as hedge funds, are able to change their risk-profiles very quickly. 2 One company reportedly secured a US$500m loan from a national bank at just 150 basis points over LIBOR despite having negative net worth, no working capital and US$50m of operating losses. See Driving home the core principles by George Graham, Financial Times, October 2nd

3 2.3. OTC and off-balance-sheet activity 2.4. A traditional view is that OTC and exchange-traded markets require different regulatory approaches because of their different characteristics. Quite apart from the fact that OTC markets are largely decentralised, involving transactions between large principles, it has been noted that such markets do not perform the same pricediscovery function as exchanges and that, as a result of the relative sophistication of market participants, financial integrity and customer protection are likely to be less urgent than in exchanges However, this view is being increasingly re-assessed in light of recent developments in OTC markets including innovation (such as the emergence of new end-users, the introduction of new products, the standardisation of prevailing products and proposals for centralised execution and clearance facilities) and explosive growth in trading activity which have raised concerns in several areas OTC and off-balance-sheet activity have grown very rapidly in recent years. The notional value of new transactions in interest rate swaps and options and in currency swaps is reported to have increased by 46% in the first six months of 1997 compared with the previous six-month period. Outstanding contracts at the end of June were worth nearly US$29 trillion 13% higher from end-1996, 62% higher from end-1995 and over 150% higher than from end Estimates suggest that the value of OTC derivative transactions is over US$860 billion In light of this growth, concerns have been raised over several issues including the difficulty in monitoring OTC and off-balance-sheet activity compared to that which takes place on-exchange for example and the reported rise in the number and size of OTC-related losses, especially in respect of derivatives, among a wider scope of institutional investors. These concerns tend to stem from the relative ease with which such instruments can provide leverage, and hence amplify risks; their ability to facilitate complex speculative positions; and the fact that they are, by and large, opaque to accounting recognition, measurement and disclosure There is some concern that certain OTC instruments facilitate excessive risk-taking by market participants. While there is some debate as to whether they encourage market participants to assume too much risk, it is generally accepted that such instruments make it relatively easy for users should they wish to do so. This is because, by affording leverage and low transaction costs, they facilitate the taking of speculative positions. Thus, they amplify the risks associated with holding them for the potential of much higher rewards. Moreover, it has been argued that if designed in particular ways, such instruments might also enable market participants to 3 A concept release issued by the Commodity Futures Trading Commission on May 12th 1998 is one attempt at this. See the Proposed Rules section of the United States Federal Register, volume 63, number From the testimony of the chairman of the Commodity Futures Trading Commission before the United States House of Representatives committee on banking and financial services, concerning the OTC derivatives market, on July 24th

4 circumvent prudential regulations or controls, and thus allow them to assume more risk than they otherwise could have These features are exacerbated by the fact that OTC instruments, through particular features such as complex pay-off structures and cross-border components, can be opaque to on-balance-sheet accounting techniques. It is argued that this makes it easier for market participants to circumvent (or at least only partially comply with) domestic capital controls, reporting requirements and prudential regulations, thus effectively hiding the financial system s true exposure to market and liquidity risk from authorities. It has also been suggested that the use of such off-balance-sheet products has complicated the distinction between traditional measures of long- and short-term foreign debt exposure, as well as of direct and portfolio investment from abroad Possible ways forward 3.1. The issues raised above suggest a need to strengthen the regulatory environment surrounding the use of leverage in financial markets. This section proposes relevant issues for prudential regulation of lenders and borrowers and the supervision of OTC activity that can be explored Prudential regulation of lenders and of borrowers One issue is whether and how regulators should tighten rules on lending. One approach might be to impose higher capital charges for loans extended for the purpose of trading. Given the short -comings of current risk-based capital requirements, especially in relation to credit risks, regulators might consider introducing lending restrictions, possibly against counterparties that have poor reporting of trading strategies, and of counterparty and market risk exposures; and ensuring that banks rely on their own risk management and controls and not of their counterparties Another issue relates to the appropriateness of imposing prudential requirements on market participants that face significant liquidity risk. Various commentators have noted that, as such investors take on more prominence in global financial markets and as institutional distinctions become less clear, there may be a need to consider improving prudential standards for certain types of large investors such as hedge funds and international mutual funds. It is argued that the risks being borne by them increasingly involve liquidity management problems and a higher exposure to macroeconomic effects. Moreover, it is thought that these risks are greater within the context of increased financial globalisation and integration. 5 There are, of course, other reasons why caution is needed in interpreting measures of long- and short-term capital flows. 4

5 In this regard, some commentators have suggested the need for imposing some form of risk-based liquidity requirements on investors that are exposed to the risk of maturity mismatch in their assets and liabilities. Concerns have arisen that liquidity management in the face of heavy redemptions may become an issue not just for the investors concerned but ultimately also for the lenders from whom they may have secured financing and through market impact effects for the markets in which they are invested. Commentators have pointed out that, as a result of various competitive factors, institutional investors are likely to engage in the faster settlement of redemptions. This, they suggest, places a strain on these investors ability to manage cash and thus encourages them to liquidate their investments far more readily for the sake of raising liquidity Critics have argued, however, that imposing such prudential standards raises private costs. Moreover, it is altogether unclear what form such requirements should take. Another approach to liquidity risk, others have suggested involves the establishment of a safety-net mechanism for large investors. However, it is recognised that this is not without its shortcomings either, chief among them the problem of moral hazard Nevertheless, measures to act as a buffer against liquidity risk might be reinforced by requiring fuller disclosure by lenders and borrowers in relation to their major market exposures. In the case of lenders, this would require reporting of both on- and off-balance sheet exposures to major borrowers, especially those that are active in financial markets. International investors, would have to report not only of their exposure to various market risks, but also to credit risks that arise from their substantial borrowings Increased transparency and better surveillance of OTC and off-balance-sheet activity A major implication of recent OTC market developments is that, in as much as issues related to regulatory objectives, such as market integrity, are valid across all financial markets, then standards upholding those objectives should be established and enforced in OTC markets as well. In particular, the regulation of OTC markets needs to be more consistent with that of exchange-traded markets A particular concern is that the existing structure of OTC markets results in an opaque environment that can stymie and frustrate policy-makers in their attempt to monitor market activity and take appropriate policy responses One way of making OTC derivatives activity more transparent is to establish large-trade and position reporting requirements for the OTC activity of 6 See for example Causes, Effects and Regulatory Implications of Financial and Economic Turbulence in Emerging Markets, an interim report released by the Emerging Markets Committee, September

6 significant market participants (given the blurring of distinctions between financial institutions that has been taking place, this should cover the major banks, securities firms and institutional investors). Such requirements would entail placing the onus back on market participants to disclose fully the nature and size of their OTC positions in various asset markets to the relevant authorities One jurisdiction supports large-exposure reporting and position monitoring of all large participants (including those outside of bank, broker and investment bank intermediaries) albeit only to the OTC foreign-exchange market. Nevertheless, the experience is encouraging because it shows that, even in a large decentralised environment such as the one in which OTC foreign-exchange trading takes place reporting requirements seem capable of being applied. But it should be noted that in order to be effective, such requirements are likely to require a concerted international effort, rather than unilateral efforts at the national level However, reporting requirements, while useful in providing a regular indication of participants trading positions, are not likely to allow for the effective monitoring of OTC trading activity. One major reason is that the trading positions of major market participants can and are likely to change very quickly with the appearance of profit-opportunities whether perceived or otherwise. Under the current structure of OTC markets, it is very unlikely that reporting requirements and market disclosures can provide authorities with anywhere near the required frequency of data for conducting the effective surveillance of OTC trading activity. It has been suggested that, given the speed at which positions can change, authorities are likely to need at least an hour-by-hour picture of a participant s on- and off-balance-sheet positions in order to assess the nature of its trading Moreover, it may not be enough simply to make OTC trading activity more transparent for authorities. It may also be necessary to improve the transparency and timeliness of trading information for the market as a whole. The availability of timely information about the trading activity of major participants may help to reduce the occurrence of speculation and the violent swings in prices that accompanies it by the broader market about the activity of a relatively small number of so-called informed investors Therefore, transparency of OTC activity might be served by bringing in certain features of exchanges that would allow for improved trade reporting and surveillance, i.e., systems that record and collate information on OTC derivative transactions, by market participant, on a timely basis for the purpose of monitoring the nature and direction of trading activity. This would entail OTC markets moving away from a de-centralised environment and operating through fragmented trading systems This would require changes in two areas in particular. First, regulation: a harmonisation of the regulatory environment would likely be necessary, as would the introduction of regulation hitherto unseen in OTC markets such as the registration of participants for specific markets. Second, market infrastructure: various markets would have to be organised and linked in such a way that would 6

7 facilitate the closer scrutiny of participants trading activity; in this respect, technology and technological standards are likely to play an important role in the collection and dissemination of information for the purpose of surveillance. 7