Review of 2016: turn and face the strange

Post-crisis reform has caused upheaval, but gave recent years a sense of direction; in 2016, that was missing

What a weird, worrying year. Confusion and conflict were rife – most obviously in the world of politics, but the mood seemed contagious. The combination of political upheaval and controversial in-flight reforms left many market participants with no clear sense of direction.

But banks were also thought to have suffered some paper losses, for example on credit valuation adjustment (CVA) – a measure of derivatives counterparty exposure. A combination of lower rates and wider credit spreads was estimated to have generated losses of $25 million or more at each big dealer. Volatility soon ebbed, but uncertainty about the impact of the vote remains. Three questions were posed in the days after the vote that are yet to be answered: on the future shape of a standalone UK's regulatory regime; its access to European markets; and whether London could retain its dominant role in euro-denominated clearing. On the latter question, French president François Hollande was quick to insist clearing would have to move to the continent – but it was much too early to be so categorical, as our Regulation editor pointed out. A related question is whether UK-based clearing houses would still be approved for use by overseas members following Brexit: this requires recognition or authorisation by the relevant overseas supervisors, a decision currently based on European regulation. "If you walked on our floor at around 7am to 7.30am this morning, it felt a little Lehman-esque in activity, size and shouting" – Frits Vogels, Icap, June 25 "Bond markets have behaved properly – the ones that have not really behaved are equity markets, such as the Nikkei, Euro Stoxx and especially the S&P. That's where we suffered most on June 24" – Bruno Crastes, H2O Asset Management, June 29 "Nothing went the right way" – head of CVA trading at one European bank, June 30 "It is the EC and Esma that will determine whether UK CCPs are equivalent, not the French president" – Philip Alexander, Risk.net, June 29 "We will need to see where the withdrawal agreement ends up between the UK and the EU before we know for sure how third countries such as the US will treat UK CCPs from an equivalence or recognition perspective" – Simon Puleston-Jones, FIA, July 1 "Businesses dislike uncertainty and they create their own certainty if you don't present it to them" – Etay Katz, Allen & Overy, September 22 BREXIT – THE HIDDEN IMPACT One of the bigger Brexit stories only came to light months after the vote – the huge margin calls issued by derivatives clearing houses on June 24 and 27, to cover swings in a range of currencies, yield curves and stock markets. This real-life stress test for the cleared swap markets passed without mishap, but provoked debate among market participants and regulators about the concentrated liquidity risks it revealed. On the day of the result, sterling saw its biggest intraday trading range for more than 20 years versus the euro and dollar; it was also the biggest intraday range in more than five years for UK and German government bond yields, the FTSE 100 and the Euro Stoxx 50. Even US yields racked up their second-biggest intraday move in five years. The combined margin call for the largest members of CME, Eurex, LCH and Ice was estimated at somewhere north of$25 billion, with individual banks having to stump up multiple billions. In some cases, those calls had to be authorised by the top management of the banks in question.

The calls were first publicly mentioned at a Commodity Futures Trading Commission (CFTC) meeting on October 6, where banks vented their frustrations with an unnamed central counterparty (CCP). On October 19, Risk was able to reveal the full story of the industry's anger at LCH's margining practices – following that with news that LCH planned to make revisions to its intraday margining, and then with a longer article that examined the systemic risks associated with the new mandatory clearing regime.

"We had an event – it was Brexit – and one CCP behaved poorly during that, so we need to do better" – John Dabbs, Credit Suisse, October 19

"We are committed to allowing FCMs to use unallocated excess in the first intraday MDR call beginning on November 3" – John Horkan, LCH, October 20

"Suddenly having to make a 10-digit payment makes people uncomfortable" – US-based clearing head

"Brexit was a very volatile day and margins were increased as they should be in a situation like that. There is a concern that you don't want to be calling for a lot of margin in particularly volatile times if you can avoid that by having adequate margins in the first place" – Timothy Massad, CFTC

"People had known the vote was coming and had taken precautionary measures. Well, what would have happened in a surprise event? How would the industry have handled that?" – Craig Pirrong, University of Houston, October 31

OP RISK UPHEAVAL

One by one, the pillars of bank op risk management cracked or toppled this year. The Basel Committee on Banking Supervision started the assault in 2015, giving advance warning it was minded to scrap the advanced measurement approach (AMA) – under which banks were allowed to calculate their own regulatory capital requirements.

Official proposals arrived in March this year, triggering a fierce pushback, but not a unanimous one. Writing in Risk, one former op risk manager agreed with regulators that the models were too complex.

As the year draws to a close, all the indications are that the AMA is dead and buried. But regulators are thought to be looking for a way to make its replacement – the standardised measurement approach (SMA) – more forward-looking. Critics of the SMA object to the fact that a bank's loss history would be the sole determinant of its capital requirements, meaning there would be no capital incentive for an institution to tighten up its practices in response to an event.

As one illustration of the SMA's impact, Risk revealed in November that Deutsche Bank could face a lasting capital hit as a result of its pending Department of Justice fine for the issuance and underwriting of mortgage-backed securities. In its current form, the SMA is also thought likely to see a bigger capital jump at European banks than US institutions.

The other sacred cows threatened this year were key risk indicators – practitioners argued their value is being undermined by weak risk culture at many organisations – and the 'three lines of defence' model, a theoretically elegant approach to risk management that falls down in practice, according to some banks.

"While internal models are an essential part of risk management for many banks, the question is what role they should play in prudential rules. This is particularly relevant for operational risk" – Bill Coen, Basel Committee on Banking Supervision, May 18

"It isn't the mathematics that I struggle with, but the fairy-tale stories that are used to justify all the adjustable parameters, which are generously stuffed into the typical AMA model" – Ruben Cohen, operational risk consultant, July 5

"Under the SMA, the impact [of a $14 billion settlement] could be way above$14 billion" – New York-based operational risk manager, November 1

"Our initial estimates are that the impact on the US banks would not be very significant, and that's how we want it to be" – regulatory source close to the Basel Committee, April 11

"The three lines of defence is a great theoretical concept, but to put it into practice well is exceptionally difficult" – Sam Lee, Sumitomo Mitsui Banking Corporation, August 17

"It is really hard to get the initial population right for KRIs" – Ann Rodriguez, formerly GE Capital, February 16

THE HARSH REALITY OF LIBOR REFORM

The world's central banks and regulators have been commendably frank and open about the need to replace Libor as an interest rate benchmark. Back in 2014, a group of 21 officials from 11 countries concluded it would be dangerous to continue anchoring derivatives and other instruments to a shrinking interbank lending market, even after reform of the Libor quoting process.

At the start of 2015, national working groups began the harder work of deciding what to replace it with. They have found the options for a new risk-free rate (RFR) are limited, partly because volumes in some of the candidate markets have been shrinking.

A second problem is that, while the industry might recognise the benefits of a new rate, many quail before the huge logistical challenge of transitioning to it. Regulators have been stepping up the hearts-and-minds rhetoric this year, but with little obvious effect.

"Who we must convince are the major dealers who offer you these swaps, and encourage and require customers to move into new products, which they don't want to do unless regulators encourage that process as well" – Darrell Duffie, Stanford University, January 26

"It isn't realistic. It is such a painful process that people won't change that quickly" – senior rates trader at a US bank, March 7

"Without robust and reliable RFRs that are ultimately embraced by end-users, the reform process is incomplete" – Chris Salmon, Bank of England, May 16

"It turns out that there just aren't that many active fixed-income markets. Or at least, active enough to support a rate" – David Bowman, Board of Governors of the Federal Reserve System, November 10

STANCHART'S CVA SHOCKER

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The week on Risk.net, November 10-16, 2017