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Regulation With a Clap of Thunder and a Massive Hammer

20 November 2013  |  1778 views  |  0

Two important events happened in November 2013. First, the Fed released its latest stress test definitions, to be used as the basis of the Comprehensive Capital and Analysis Review (CCAR) report, due in March 2014. Second, Thor returned to cinema screens in the action sequel, ‘The Dark World.’ So, why are these two things collectively important?

While seemingly unrelated, Thor is actually a remarkable and timely metaphor for modern regulatory practice: protect the system first, the system’s participants second, and remember to carry a big hammer.

To understand the connection, it is important to explore what Thor represents. The god of thunder and his hammer ‘Mjollnir’ have featured in Northern European folklore for many centuries. With his mythological roles including being the god of thunder, protector of mankind and defender of Asgard (the home of the Norse gods), Thor is typically depicted as having a black-and-white sense of right and wrong. Therefore, he is more concerned with safekeeping the balance within the mythological system rather than the safety of any particular participant of the system.

The current regulatory approach in financial markets globally has been constructed in the shadow of the last credit/liquidity crisis. At the heart of new regulation lies the aim of ensuring that the framework of the financial system is not threatened by any given bank’s specific risk profile. Simply put, market players are supposed to plan and run their capital activities and structures in such a way that each can survive defaults and failures of any of their peers. Also, it is important for the larger tier-one banks to be able to survive deeper global shocks. And the public reporting of a bank’s pass/fail status ensures that there is a significant reputational cost to failing these tests in the eyes of the regulator.

Back to Thor. He of course has a second identity, outside of his role as a Norse god. Since the 1960s, the hammer-wielding Asgardian has also been a staple in Marvel’s superhero universe, being both a significant individual hero and a founding member of its principal team, The Avengers. It is within this second persona that Thor returns to the silver screen.

What is interesting is that the film itself is set against a backdrop of Thor being somewhat responsible for preventing cataclysmic events for both the Earth (Midgard) and the other realms he protects. This is exactly in line with current stress test definitions as defined by the Fed.

The ‘global shocks’ in stress tests are designed for the largest banks only, as they are seen as being systemically important on a global level. The events in question are typically extreme but plausible, and the results enable the regulatory bodies to determine how weakened the U.S. financial system would be, in terms of available capital, credit and liquidity, in the face of such events.

For the rest of the banks capitalized at over 50b, there are three sets of scenarios, each looking out nine quarters. There is a base case, a severe and a very severe scenario for the entire timeframe, making twenty seven scenarios. The scenarios themselves are expressed in terms of ‘macro’ factors such as oil shocks or inflation, and banks are expected to interpret these and apply them to both their banking and trading books. The banking books lend themselves to evolving scenarios, as most exposures are longer term by definition. The trading book requires that banks take a ‘constant risk profile’ view such that the twenty seven scenarios can be treated as instantaneous shocks, consistent with the view that short-term maturities within the trading book would be replaced with positions of similar risk in any case. Importantly, banks need to be able to defend their interpretation of the shocks into the final scenarios, which means performing a defensible regression analysis over a suitable time period.

Once the shocks have been run and aggregated as results over the nine quarters, the capital plans are overlaid and the Fed has a view of what the system itself would look like, assuming deteriorating market conditions and capital activity by the market players. These results will be graded as pass/fail and will be published as such in March 2014. Given the parallel introduction of the counterparty ratings requirement, which asks banks to reduce reliance on external ratings agencies, it seems like a logical consequence that these results will form a major building block in the internal ratings process, doubling  the potential penalties when the hammer comes down for ‘failing’ these tests.

In the latest Thor film, the scientists who have foreseen a terrifying cosmic occurrence do have the power to prevent damage to Earth, and really only need Thor to ensure they have the opportunity to deploy that power. This is, again, exactly what the latest regulatory design is aiming for. Enabling and ensuring that capital is used in such a way that systemic shocks can be absorbed while leaving the financial framework intact are the overriding goals of the Dodd-Frank Act.

In case the obvious metaphor is missed by the cinema-going public, Thor, and most specifically his magical Mjollnir, tears through many of the iconic buildings in London’s financial heartland, demonstrating  that he is there to ensure the ongoing existence of the global system rather than the direct protection of any one player within it.

Thor, whether as the Norse god of thunder or as Marvel’s founding Avenger, is a veritable blueprint for the current regulatory regime in the United States and abroad: setting rules designed for the survival of the financial ecosystem and enforcing these rules with a strong sense of absolute right and wrong, and of course, wielding a massive hammer for regulation.

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