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Stress test scenarios miss the boat

Professor Jonathan Parker

The Dodd-Frank act requires that large financial institutions be more closely monitored for exposure to systematic risks.  A key part of this monitoring is stress testing.  Regulators announce a set of adverse scenarios, and financial institutions calculate and report their losses in each scenario.  Regulators get to see how exposed the institutions are.

The OCC has now released the scenarios for 2014.  You can easily download and look at them here.  The scenarios detail lots of economic outcomes: each scenario has 28 variables that mostly turn bad.  But I am really disappointed – this regulatory approach is not addressing the financial-crisis type exposures at all.

There are only three scenarios, one of which is the baseline scenario. The other two are really two typical recessions – one bad, one worse.  What use is this?  Where are those once a century scenarios, like a house price collapse?  Where are the unlikely but possible bad scenarios like a run on the US dollar or US debt?  How about a large fiscal inflation?  In none of the adverse scenarios do long interest rates.  My suggestion: reverse the detail – more scenarios, each with fewer variables.  There are many factors in asset pricing for a reason – there are many sources of risk.  Regulators seem to think there is only one.  Be more creative. Think about unlikely bad outcomes  That’s the entire benefit of the exercise.  Make banks think about these scenarios; make regulators aware of how bad (or not) the unlikely scenarios would be.

Large financial institutions do not have to evaluate their losses in the scenarios that keep me up at night.  I hope the regulators also do not sleep so well.

Jonathan A. Parker is the International Programs Professor in Management and a Professor of Finance at the MIT Sloan School of Management.

Fear of the Future-ization of Swaps

Dr. John Parsons (right)

Title VII of the Dodd-Frank Act mandates the regulation of the OTC swaps market in a fashion that parallels the pre-existing regulation of futures markets. Although the Act was passed in 2009, many of its provisions are only now beginning to take effect. One current manifestation is the resorting of derivative trades across the two marketplaces as traders reassess the relative cost of swaps versus futures in light of the changed regulations, moving important pieces of the business from the OTC swaps marketplace over to futures exchanges. The futures industry is actively encouraging the trend as it designs new “swap futures” products designed to mimic the payoffs to swaps while benefitting from the regulatory rules applicable to futures markets.

The process is being called the futurization of swaps.

In January, the Commodities Futures Trading Commission (CFTC) hosted a public Roundtable to get input from the industry and academic experts on the process. Dr. John Parsons, Senior Lecturer in the Finance Group at Sloan and Head of the MBA Finance Track, was one of the invited participants. Dr. Parsons has covered the futurization process on his blog, “betting the business” since the first big waves began in August of 2012.

His comments at the Roundtable made 3 points:

1. They’re all just derivatives.

For any liquid swap contract, the futures exchanges can produce products which mimic the financial properties of the swap. So from a social point of view, it’s a matter of indifference whether the risk is marketed on a futures exchange or on the new regulated swap execution facilities.

2. Dodd-Frank leveled the playing field.

The swap industry complains that futurization is a case of regulatory arbitrage. But the truth is the other way around. It was the lack of regulation pre-Dodd-Frank that gave the OTC swaps market its edge. By imposing (i) universal regulatory supervision, (ii) transparency and (iii) clearing on the majority of swaps contracts, the Dodd-Frank act has erased the major regulatory differences between the two markets. Furturization is a natural result of eliminating regulatory arbitrage.

3. Keep your eye on the ball.

The OTC swaps market continues to be the only option for illiquid and customized derivative products. It makes no sense to try and fashion duplicative rules for two parallel market structures – one for futures exchanges and a second for swap execution facilities – that are both well suited for liquid and standardized derivatives. Instead, regulators should tailor the rules for the swap marketplace to suit the service that the swaps marketplace is uniquely capable of providing.

A video of the Roundtable is available on the CFTC website, here, and the transcript is available here.

A set of Dr. Parsons’ blog posts on various aspects of the subject of futurization can be found here.