A Simple Alternative to the Volker Rule

There are several broad ways to regulate risky behavior. One is to limit or entirely prohibit certain behavior. Another is to require the risk takers to hold capital for the risks.

For some strange and unknown reason, banking regulators have not considered asking banks to hold appropriate capital for trading losses. The evidence is extremely clear that banks can lose much more than the VaR measure suggests.

There is a very simple way to correct this matter. Banks have reasonable capital requirements for credit operations. These requirements are based upon observations over multiple credit cycles, not small parts of a cycle as is VaR.

All bank capital requirements need to be based upon multiple cycle observations.

But some would say that most derivatives have not existed for multiple market cycles.

There is a simple solution for that. One of the primary rules of modern finance is the law of one price. Regulators should insist that law be applied to capital requirements as well.

Right now, a bank that borrows money to buy a bond of a company would hold capital based upon the probability of default of the bond and the expected loss given default. If the trading desk buys a CDS with the exact same expected net cash flow, they hold capital based upon the recent short term fluctuations in market price of the CDS. In some cases, as little as 10% the capital of the replicating assets.

That means that with the same amount of capital, the trading desk can take 10x the risk.

The VaR calculation used for derivative positions rarely captures the same amount of risk as a replication of the position.

The alternative to the Volker Rule would be to require capital that is:

Based upon volatility over several market cycles and

Consistent with the law of one price.

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