Perspective on Risk - June 23, 2023
Unprecedented Heating; SRE vs OLA; When The NY Fed GC Talks; SVB Deposits; Warsh’s Proscriptions; Stress Testing HFs; Beyond Moore's Law; The Risk of LLMs; More Nickel & Wirecard; Winning Arguments
Shouting It From The Roof Top
We are witnessing unprecedented heating. And it seems nobody cares, except the climate scientists I follow.
The total energy associated with the 0.7°C increase above previous highs, just to heat the top 1 meter of the North Atlantic Ocean, is estimates : 0.112 ZetaJoules
That's about 1.8 million Hiroshima bombs of heat!
Or 19% of all the energy we use in one year (~0.6 ZJ)!
We are well above 3 sigma - I’ve seen estimates suggesting ~5 sigma move.
SVB/Signature Systemic Risk Exemption
During Wednesday’s semi-annual monetary policy oversight hearing of the US House Financial Services Committee, Rep. Huizenga asks:
Huizenga:
Along with the FDIC and Department of Treasury you invoked the systemic risk exemption, the SRE, for both Silicon Valley and Signature Bank guaranteeing all depositors will be made whole.
Regulators could have used Orderly Liquidation Authority - a very tool Dodd-Frank was intended - to resolve the quote too big to fail institutions while protecting taxpayers.
Why was the decision to use SRE made, and do you think that we've now lowered the bar to use SRE and future bank failures?
Powell:
I hope we don't have to face that question we all do as long as I live.
This this happened with no warning in the middle of the night Thursday night and less than 12 hours later we're on the phone with the FDIC and they're they're deciding to close the institution and to haircut uninsured depositors so it was it was an emergency situation over that weekend - we could see that there was an electronic run building up and we we did what we had to do to address that and I think successfully
I’m sorry, the regulators shouldn’t have been surprised.
When The NY Fed GC Talks, One Should Listen
Richard Ostrander made the following remarks at the Paris Meeting of the Committee on International Monetary Law of the International Law Association; Remarks on the Panel “Bank Crisis Framework: Learning from Experience” There are a number of interesting observations in these remarks (highlighting is mine).
BTFP Is Regulatory Forbearance
In it, he explicitly says the goal of the BTFP was regulatory forbearance (without actually saying the words):
Along with the goal of enabling financing up to the face value of these securities, the Fed concluded it would be helpful to the borrowers for the term of the loan to be set at one year. The thinking was that committed financing of these securities would significantly mitigate any concerns market participants had that a bank would need to realize losses on these securities.
He goes on to discuss the details of why the BTFP was set up in the way it was. He specifically says that the BTFP was set up in contrast to Bagehot’s dictum “to avert panic, central banks should lend early and freely, to solvent firms, against good collateral, and at 'high rates'".
There was not enough time to set up special purpose vehicles as the Fed had done for some of the pandemic programs. The only way to have the program up and running so quickly was to leverage our discount window facilities.
However, our discount window authority—Section 10B of the Federal Reserve Act—does not authorize reserve banks to lend for a period greater than four months. In addition, under traditional discount window policies, loans are extended against collateral that is assigned a lendable value by the reserve bank based on a haircut applied to the asset’s fair market value. Under the circumstances we faced, traditional discount window operations could not fully meet the acute needs of the banking sector.
So they chose to use 13(3) authority.
As a result, we turned to Section 13(3) of the Federal Reserve Act, which authorizes specialized lending in unusual and exigent circumstances.6 The BTFP extends the maximum term of lending from the Section 10B limit of four months up to a special limit of one year. Additionally, unlike traditional discount window operations, the BTFP authorizes banks to borrow against eligible holdings up to their par value rather than their market value less a haircut.
And received a Treasury coverage of first loss.
The Treasury Department has agreed to reimburse the Federal Reserve for aggregate losses on BTFP loans up to $25 billion.
I haven’t looked at the timing here, but this may be the proximate reason for the systemic risk exemption; the need to use 13(3) authority rather than 10B authority.
NY Fed Discount Window Took Extraordinary Actions To Lend To Signature Bank
When Signature reached a critical point in its fight for survival, its personnel were unfamiliar with the operational processes and requirements to use the New York Fed’s discount window.
New York Fed identified an ad hoc solution that enabled Signature to borrow late on Friday, March 10. Under Section 10B, discount window loans must be sufficiently secured.11 Normally, the Fed establishes and perfects its security interest in Fedwire-eligible securities, such as Treasuries, Agencies, and Agency MBS, by requiring the borrower to transfer them to the borrower’s pledge account at the New York Fed. In this case, however, we worked with the Federal Home Loan Bank of New York and with Signature to enter subordination and pledge arrangements that provided the New York Fed with a perfected priority security interest without transferring the securities.12 This satisfied the Section 10B requirement.
Expect to See Firm Deadlines to Clear Supervisory Findings
Regulators and supervisors can minimize the impact and probability of bank failures, but they cannot prevent all banks from failing.
I find it fascinating that in his testimony before the Senate Banking Committee, when asked why action was not taken with respect to a finding on interest rate risk, the former CEO of SVB downplayed a “Matter Requiring Attention” (or MRA) as the “lowest level” of supervisory finding. The fact that an issue becomes a supervisory finding at all means it is important!
A key lesson from SVB’s failure, then, is that management can become desensitized over time to the seriousness of findings—especially where they are allowed to linger without consequences.
Looking ahead, perhaps supervisors should prescribe more exact timetables for addressing MRAs and MRIAs—deadlines that are realistic, but firm.
Corporate Governance
Though SVB had a risk function, it was headed in the absence of a chief risk officer by the chief executive officer. That does not strike me as an effective way to challenge the risks undertaken to promote growth, since growing a business is a chief executive’s job. I question whether, lacking a leader, SVB’s risk management team had a clear, credible voice capable of communicating critical feedback to the management team and, ultimately, to the board. The chief risk officer plays that role. Without that officer, perhaps no one was in a position to encourage the bank to slow down and focus on managing some important risks in the midst of its rapid growth.
FDIC Accidentally Releases Largest SVB Depositors
The Big Names That Got Backstop for Billions in Uninsured SVB Deposits
A document from the Federal Deposit Insurance Corp., which the agency said it mistakenly released unredacted in response to a Bloomberg News Freedom of Information Act request, provides one of the most detailed glimpses yet into the bank’s big customers.
Many #Fintwit commentators are not happy and believe that this is proof of a VC bailout.
However, as I have stated above, and taking Powell and Ostrander at their word, the regulators were asleep at the switch. Or as Powell puts it:
This this happened with no warning in the middle of the night Thursday night
Sorry, there was plenty of warning, including a presentation to the full Board that you attended months before.
Warsh’s Proscriptions For Preventing Banking Crises
Fed President Kevin Warsh wrote How to Prevent Another Financial Crisis for the Wall Street Journal.
If the problems in commercial real estate presage a repricing of other assets, more banks will struggle to maintain adequate capital and liquidity. If the share prices of small and midsize banks come under renewed pressure, small and medium-size businesses will suffer a credit crunch. If the economy weakens, credit quality will deteriorate. And if inflation remains stubbornly high, the Fed will raise interest rates to 6%. Financial markets would bristle.
Ms. Yellen and the other policy makers on the Financial Stability Oversight Council should take immediate action to mitigate these risks. They should promote the private recapitalization of small and midsize banks so they survive and thrive.
Some will recall that I thought this would happen in the immediate aftermath of SVB; still should happen, and not the government/regulators may have to mandate it.
Bank regulators have long looked askance at capital from asset managers and private equity firms, among others. But this is no time for luxury beliefs. Such investments should be promptly pre-approved, so long as they are passive and governance rights circumscribed. Private capital is far superior to government capital because it will more effectively ensure the prudent provision of credit and a more competitive, resilient banking system.
Unfortunately, I suspect “passive” and “circumscribed” will be difficult to implement with Congressional input, but with the institutionalization of asset management, this may be inevitable.
Policy makers should also green-light consolidation among small, midsize and even larger regional banks. I recognize concerns about market power. But the largest banks have already secured a privileged position with their “too big to fail” status. Hundreds of banks need larger, stronger franchises to compete against them, especially in an uncertain economy.
Agreed, provided that the consolidation increases the competition for the TBTF banks.
Hedge Fund Stress Test
Bloomberg has a story, Hedge Funds to Face First Ever Stress Tests Under BOE Exercise, that the Bank of England ask firms (hedge funds, pension funds and other financial firms, including banks, insurers and clearinghouses) to consider how they would react to a severe stress to global financial markets. The BOE will then analyze their collective responses, for example a fire sale of assets.
This is a nice example of the kind of exercise a prudential supervisor tasked with systemic risk responsibilities should undertake. It will provide information not only about market structure, but about possible behavioral channels. It will show where assumptions of different market players are not aligned.
Here is how the BoE puts it:
The Bank’s system-wide exploratory scenario will investigate the behaviours of banks and non-bank financial institutions following a severe but plausible stress to financial markets. It will consider both what drives these behaviours and their consequences, and will focus on the potential for these actions to interact and to amplify shocks in ways that might cause adverse outcomes in UK financial markets core to UK financial stability.
This will be an exploratory exercise focused on market resilience and its importance for financial stability; it will not be a test of individual firms’ resilience.
The Bank will ask a range of institutions whose activity it judges to be most relevant to core UK financial markets to participate in this exercise. Firms approached to participate are strongly encouraged to prioritise this work, which will improve understanding and contribute towards the remediation of vulnerabilities that continue to pose risks to UK financial stability.
The Bank will publish more detailed information on the exercise in Q2.
GPUs Have (Exponentially) Accelerated Moore’s Law
RIP Gordon Moore.
Managing The Risk of LLMs
LLMs Taking HIPPA Compliance Seriously
Not sure about the others, but this is good to see; should accelerate adoption.
Compliance with Draft EU Requirements
Stamford took a look in Do Foundation Model Providers Comply with the EU AI Act? Your IT folks will like this.
Our assessment demonstrates that it is currently feasible for foundation model providers to comply with the AI Act, and that disclosure related to foundation models’ development, use, and performance would improve transparency in the entire ecosystem.
AI Risk Insurance
Is AI Risk Insurance the Next Cyber for Insurers?
For legal purposes, AI is treated as advanced or complex software. As such, current cyber risk insurance covers AI-related risks surrounding data breaches, business interruption due to a cyber attack, privacy liability, deep fake cyber extortion, cyber stealing attacks, data leaks, network security liability and notification costs. When AI is incorporated into physical products like autonomous vehicles, robots and industrial machinery, product liability insurance may also apply. This insurance typically covers physical injury and third-party damage caused by design defects, manufacturing process or production flows, and marketing/sales errors.
Nevertheless, these insurance products do not cover algorithmic liability or ethical and regulatory risks.
Algorithmic liability pertains to the potential legal responsibility of a company arising from decisions made or actions taken by an algorithm. The legal liability emerges when the product or solution sold by the company’s AI product results in financial, physical or psychological loss.
As more of the algorithmic decision-making shifts from augmenting humans to becoming more autonomous, the risk of algorithmic liability increases.
There are strong similarities between cyber risk and AI risk that can guide insurers in shaping the evolution of AI risk insurance products. However, there are also significant differences between the two that can help insurers develop AI risk insurance strategy.
The adoption of generative AI, particularly the use of LLMs and Q&A services built upon them (e.g., ChatGPT), has occurred at an exponentially faster pace.
The scope of generative AI applications, which broadens the spectrum of risks, is also notably larger.
AI risk is also likely to be interconnected with other risks more extensively than cyber risk. In addition to cyber risk and product liability risk, AI risk is also linked with reputational risk, business continuity risk and regulatory risk.
Tracing liability … will likely pose a significant challenge.
More on the LME Nickel Market
Bloomberg has gone through numerous court filings: What Really Happened the Night the Nickel Market Broke
Documents made public in a court hearing this week recount in unforgiving detail the LME’s fateful decisions in early March, and how it sleepwalked into a crisis with little precedent in the modern history of finance.
Summarizing:
the LME was largely in the dark about Tsingshan’s role as the major driver of the price spike until after it had decided to cancel billions of dollars of nickel trades;
the exchange’s top decision makers were asleep as the market spiraled out of control; and
Chamberlain made the key decision that the market was disorderly in about 20 minutes after he woke up on March 8 – unaware until much later that the LME’s staff had allowed prices to move more rapidly by disabling its own automatic volatility controls.
Digging further, Bloomberg writes: UK Regulator Was Missing in Action at Start of Nickel Crisis, Filings Show
The UK’s market regulator had only superficial engagement with the London Metal Exchange as it sleepwalked into last year’s nickel crisis, according to information made public as part of a legal battle between the exchange and aggrieved traders.
A senior LME executive complained at the time the regulator’s questions were “ridiculous,” according to a redacted transcript from a group Whatsapp chat provided to Bloomberg on Thursday.
Update on Wirecard
Singapore hands down first Wirecard criminal convictions
Singapore has handed down prison sentences to two former senior Wirecard finance executives, the first criminal convictions related to the collapse of the once high-flying German payments group.
James Wardhana was sentenced to 21 months and Chai Ai Lim to 10 months by Singapore’s state court on Tuesday with immediate effect for conspiring to misappropriate funds. Both pleaded guilty after being charged in 2022 alongside two other people in connection with the case.
38 Ways To Win An Argument
Truly horrible techniques for reaching a consensus and building relationships. But useful to know and understand for when they are being used against you. I’ve been accused of #36.