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Sunday, February 05, 2006

Banks, CDOs, leverage

Jayanth Varma has an extremely funny blog entry which responds to an article in The Economist. The article is a gloomy piece about Collateralised Debt Obligations (CDOs), which the journo portrays as dark and dangerous instruments. JRV points out that everything the journo says could equally be said about bank loans, but then, the moment someone utters the magic word `bank', all skepticism is suspended. The journo has the usual `financial innovation is dangerous' worldview - e.g. cash settlement is bad, and so on.

I have an extension on his theme, this is about leverage. When we look at any normal company or business plan, we are extremely conscious about leverage. Every sensible person knows to watch out for the leverage. People who don't like derivatives talk about the enormous leverage of derivatives positions - e.g. in India, the Nifty futures give you roughly 6:1 leverage. By putting down cash of only Rs.15, you can get a position of notional value Rs.100.

How does this enormous leverage work out okay in the derivatives field? The main answer is: good financial and computer engineering. This is the entire edifice of VaR, initial margin, daily mark-to-market margin, novation at the clearing corporation, etc. A sophisticated synchronised dance is pulled off, and it works out well.

In contrast, ponder the leverage of banks. The average leverage of banks in India is 20:1! Banks - supposedly the bastion of safety and the backbone of civilisation - have a great deal more leverage than the supposedly wild derivatives market.

And the banks do a terrible job of handling it. The financial and computer engineering that has gone into exchange-traded derivatives is infeasible with banks. Banks don't do daily mark-to-market. There is no VaR, there is no novation at the clearing corporation, etc. A bank is just one big opaque leveraged position.

ps: Sometimes people think the "capital adequacy ratio" of the Basle Capital Accord (1988) shows the amount of equity in the bank. That is not so - the CAR is just a formula invented by Basle. A bank may say it has a CAR of 12%, but it may have 20:1 leverage all the same. I like to compute the simple number - Total Assets divided by Equity Capital - as a simple metric of leverage. Leverage is about asking: How big is your position? And, how much equity do you have in it?

Update: a response by Jayanth Varma.

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