The much anticipated unveiling of the Volcker Rule this week appears poised to prohibit banks from engaging in broad-based risk mitigation strategies referred to as portfolio hedging. Banks, to a certain degree, have themselves to blame for this expected ban, given their inability to self-govern massive risk-taking. Still, a prohibition on portfolio hedging would perfectly illustrate the current practice of regulatory "populism" that has pervaded financial regulatory reform since the crisis.
To put the prospective ban on portfolio hedging in perspective, imagine a state in the Western United States where posted speeds on interstate highways are 75 miles per hour. One day, following a single car highway fatality, that state's legislators impose a 45 mph speed limit on all roadways. It's a fair bet the majority of drivers would be irate and in a state of shock over such an outcome. Driving 45 mph under certain road and climate conditions makes sense, but for some road types, such as interstate highways 45 mph is clearly too slow. And so banning portfolio hedging is not unlike moving to a speed limit that makes us feel good for the preventative aspects it brings, but winds up being counterproductive in the long run.
The idea that risk exposure from an unhedged portfolio of assets should not be hedged at an aggregate level ignores significant challenges faced by banks on executing effective hedging strategies that offset stated risks at the lowest cost possible.
The problem with the London Whale episode at JPMorgan Chase was not that it was a portfolio hedge gone bad, but that management failed to put in place proper risk governance practices and the regulator failed to monitor and react to these developments in a timely fashion.
I oversaw the application of hedging strategy for various large banks, and I currently teach hedging and derivatives courses to business students.
Portfolio hedging in many instances is an effective risk mitigation strategy for banks. But just as there are drivers who take unreasonable risks with their driving habits by texting while driving at excessive speed, most drivers obey posted speed limits, getting them where they need to be safely and efficiently. Billions of dollars of mortgage servicing rights, mortgage commitment pipelines and other aggregate positions are safely managed every day by using forms of portfolio hedging. Actively managing portfolio risks is a hallmark of prudent risk management practice. And for some embedded portfolio risks such as credit risk, it makes sense to use a combination of derivatives instruments to offset potential losses under adverse market conditions.
The key to managing such risks lies in effective governance and controls at the institution level, coupled with vigilant oversight by bank supervisory agencies. With proper controls in place, it is highly unlikely the London Whale incident would have ever occurred.
So what are the necessary conditions to allow portfolio hedging?
First, management must explicitly define the nature and size of the risk reflected by the unhedged position. A written hedge policy should outline: the rationale behind the hedge strategy; the risk tolerance for the net unhedged and hedged position as reflected in standard measures such as value-at-risk; policies and procedures for unwinding hedge positions and deployment of risk models; identification of the accountable officers of the company; and approval by the independent corporate risk management office. This policy document would form the basis of ensuring senior bank officials and supervisory agencies are aware of significant hedging activities over the course of the strategy.
These are not difficult or overly cumbersome requirements to impose on firms and they would provide the necessary guardrails around excessive risk-taking in portfolio hedging activities.
Instead, the easier road for regulators to take is to ban all uses of portfolio hedging. So now does every commitment in a mortgage pipeline require separate short futures or long put option contracts to offset the mortgage commitment's interest rate risk exposure? And at what cost? Regulation made in response to a single isolated event such as the London Whale incident is simply bad policymaking and shows a predilection to take an overly simplistic approach to a complex but highly useful risk management practice. Such approaches certainly play well to the vast majority of individuals who have no idea what portfolio hedging is other than what they read in the papers.
Ultimately, such policymaking sets the financial sector on a potentially dangerous path toward limiting otherwise highly effective hedging tools from being applied which will curtail critical consumer and commercial lending activities and preclude the availability of risk mitigation techniques to banks when needed at critical points in the business cycle.
Clifford Rossi is the Professor-of-the-Practice at the Robert H. Smith School of Business at the University of Maryland.