The unknown factors in regulating capital markets Share Shah

The regulation of the financial markets is a difficult assignment. The jobs in this business may range from setting monetary policy to the maintenance of a sound and stable financial system. When a crisis such as the stock market crash or the high rate of debt default occurs, the job of such regulators (there being more than one) is to prevent them from wreaking any harm on the financial system as a whole-and they must strive to limit the consequences.
   Often bank regulators and financial policymakers are caught unaware. They are required to make decisions in times of uncertainty. During a crisis, when reliable information about the markets is scarce and people are panicked, they must act with the Wisdom of Solomon. They must not be too interventionist or too hands-off, too trigger-happy or too delayed, too confident in their actions or too meek.
   Over the past several years, financial institutions-banks, non banking institutions, merchant banks and brokerage firms have evolved and are today exposed to public dealings. There has also been increase in regulations, systems and procedure both theoretical and technical developments which require efficiency to manage risks. Such procedure cannot be operated without improving financial sector resilience through education and training.
   We have the known, unknown and unknowable risks. Known risks are regularities estimated from historical relationships. What is unknown is what will happen at any particular point in time or on any particular occasion. We may know that average default probabilities will change by a given percentage point change in interest rates, but not which loans will be affected.
   In this context, what is unknowable is how the regularity may be affected by unpredictable events or how it may change over time. An example of an unknowable event is a terrorist attack or a large-scale natural disaster like the cyclone 'Sidr' of 2007 or the Indonesian earthquake and tsunami.
   What makes unknowable events or crises so difficult to handle, from the perspective of a policymaker, is the chaos that overtakes the normal functioning of markets. Information about prices is hard to come by, uncertainty prevails, and traditional measures of risk cannot be trusted. In financial terms, statistical relationships that were relatively consistent in normal times can be thrown out of whack, triggering huge losses and liquidity concerns. Within weeks the market dislocations in NY Stock Exchange brought the Long Term Capital Management, a large hedge fund with a complex "relative-value” playbook, to the brink of collapse. It controlled derivatives positions with a notional value of $1.25 trillion, and to stave off a financial disaster, the New York Federal Reserve mediated a bailout by the hedge fund's largest creditors. Then there is the risk of proprietary trading the extreme case being that of the ancient merchant bank --Bearing Brothers.
   Since predicting the scope and content of future crises is not possible, regulators learn from the past and encourage and reward the use of sophisticated risk management techniques and stress tests at banks. Risk management in general tries to shift risks that are considered unknown into the category of known risks and tries to mitigate the costs associated with things that remain unknown. Events that cannot reliably be moved into the known category are dealt with differently. Insurance, the securitisation of assets, and derivatives contracts are ways that institutions can transfer risks they do not want to hold on their books to those willing and able to accept those risks for a price.
   Risk management at financial institutions has improved over the years, and more sophisticated techniques exist to identify and manage risks, one difficulty regulators have traditionally faced is an asymmetry of information. For instance, when a regulator looks at a bank's loan portfolio, the bank has a better idea of the risks to which it is exposed than does the regulator. Unfortunately no such effort has been made in regulating margin lending which is being held outside the scope of the central bank. The modalities need to be managed as has been seen the run away lending to stock investors. This abuse may have long term effect on investors especially when there is a bear run.
   In recent years, central bank has adapted measures to improve regulatory efficiency. Banks have been required to set aside capital against the market and credit risks they faced according to a relatively simple model devised by the Basel Committee, a group within the Bank for International Settlements that formulates capital adequacy guidelines for international banks. The Basel Committee has revised the way minimal capital levels are determined. According to the new Basel II framework, some of the largest banks will be able to use their own internal ratings-based models to assess the risk factors of various bonds and credit instruments, in lieu of the blunt-force instrument they have thus far used to determine regulatory capital requirements. No such control exists in lending against shares and securities.
   The financial system may appear to be robust in recent times, and no large financial institution has gone bust and caused a systemic risk. However, that should not prevent tough decisions from being made in the future. No institution can be too big to fail. Handling the failure of a large, complex organisation-imposing the costs of failure on management, shareholders and creditors, while minimizing the effects on the wider economy-will be complicated. But we cannot allow the public interest in containing moral hazard to be held hostage to complexity.

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John Wilen in New York

Oil futures fell last Wednesday to their lowest level in six weeks after a mixed government inventory report failed to offset a belief that supplies are growing faster than demand.
   Investors shrugged off OPEC's decision to keep production levels steady, a possible sign prices have peaked for the year, analysts said.
   In its weekly inventory report, the Energy Department's Energy Information Administration (EIA) said crude supplies plunged by 8 million barrels last week, much more than the expected 700,000 barrel decline. That caused oil prices to jump briefly above $90 a barrel, but other aspects of the report weighed on prices as the day wore on.
   Crude supplies grew at the closely-watching Nymex delivery terminal in Cushing, Okla. Inventories of heating oil rose when analysts had expected a decline, and gasoline supplies rose more than expected.
   "Overall, this is a mixed report,” said Tim Evans, an analyst at Citigroup Inc., in a research note.
   Earlier Wednesday, Organization of Petroleum Exporting Countries (OPEC) ministers meeting in Abu Dhabi, United Arab Emirates, said the cartel would leave output unchanged "for the time being” because the world was "well supplied” and crude reserves are at comfortable levels.
   That also caused a brief price spike. But there are signs OPEC nations are already producing more than their quotas, and some analysts expect OPEC output to increase even further in the weeks to come.
   Light, sweet crude for January delivery fell 83 cents to settle at $87.49 a barrel on the New York Mercantile Exchange, oil's lowest close since Oct. 24. Prices continued drifting lower in after-hours trading, dipping below $87.
   Other energy futures were mixed. January gasoline fell 3.47 cents to settle at $2.217 a gallon on the Nymex, and January heating oil fell 2.25 cents to settle at $2.4893 a gallon. January natural gas rose 3 cents to settle at $7.185 per 1,000 cubic feet on the Nymex.
   In London, December Brent crude fell $1.04 to settle at $88.49 a barrel on the ICE Futures exchange.
   At the pump, meanwhile, gas prices fell 0.8 cent overnight to a national average of $3.044 a gallon, according to AAA and the Oil Price Information Service. Gas prices have fallen 6.8 cents since mid-November, when they spiked higher as oil approached $100 a barrel.
   In its report, the EIA said inventories in Cushing, Okla., rose by 700,000 barrels during the week ended Nov. 30, the third week in a row supplies there have grown. Activity at the Cushing terminal is studied closely by oil traders because it is the physical delivery point for Nymex crude. Falling supplies there are seen as a symptom of a tight market, and those concerns ease when Cushing inventories rise.
   Refinery activity was unchanged last week at 89.4 percent of capacity. Analysts surveyed by Dow Jones Newswires, on average, had expected refinery utilisation to rise by 0.1 percentage point to 89.5 per cent of capacity.
   Supplies of gasoline rose by 4 million barrels, much more than the 700,000-barrel increase analysts had expected. And inventories of distillates, which include heating oil and diesel fuel, rose by 1.4 million barrels, countering analyst expectations for a 400,000-barrel decline.
   Some of the decline in crude supplies can be explained by oil imports, which fell last week by an average 980,000 barrels a day to 9.4 million barrels a day. Gasoline imports rose last week by 334,000 barrels a day to an average of 1.2 million barrels a day.
   Gasoline demand slid last week by about 90,000 barrels, and is up by 0.2 per cent over the last four weeks compared to the same period last year, the EIA said. Analysts consider year-over-year demand growth of less than 1.5 per cent to be low.
   Oil prices have dropped about $10 from all time-highs near $100 in a little over a week on evidence of rising inventories at Cushing, on speculation that OPEC would boost supplies and on evidence that some OPEC countries are already producing more oil than their quotas call for.
   OPEC output could jump by another 300,000 to 400,000 barrels a day once oil fields in the United Arab Emirates return to service from seasonal maintenance, wrote Costanza Jacazio, an analyst with Barclay's Capital, in a research note. Last month, Saudi Arabia's oil minister said the kingdom is producing 9 million barrels a day, more than its quota.
   Analysts say a price drop on a day with bullish oil headlines could indicate that the market has begun a seasonal decline.
   "How the market finishes today could tell us what prices really want to do,” said Peter Beutel, president of the energy risk management firm Cameron Hanover, in a research note.
   AP writers Pablo Gorondi in Budapest and Gillian Wong in Singapore contributed to this report.

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