How much do traders care about capital models?

I have written before on the perverse incentive in risk sensitive capital models such as VAR, and on the suboptimal design of the Basel 2 capital accord. Reading a guest post by Avinash Persaud on Willem Buiter's blog, however, I wondered how much this matters. Let me explain. Persaud rightly points out that everyone uses roughly the same sort of market risk capital model and as a result everyone has roughly the same view of the capital against a given portfolio. Moreover this number changes as the models are recalibrated to include more recent data and thus if vols rise, capital does too. But I wonder if Persaud goes too far in what he says next:

Market participants don’t stare helplessly at these results. They move into the favoured markets and out of the unfavoured. Enormous cross-border capital flows are unleashed. But under the weight of the herd, favoured instruments cannot remain undervalued, uncorrelated and low risk. They are transformed into the precise opposite.

In a crisis certainly everyone covers at once, or at least sufficiently many people do in a sufficiently short period of time to cause illiquidity and rapid price falls. Most of the time however most traders do not use VAR to optimise their portfolios. They see VAR as at best an inconvenient limit. So they don't move into markets their firm's capital model favours: they move into markets their gut instinct, their broker or their boss favours. While capital models (and risk limits phrased in the same terms) do create an incentive structure, they are not the only nor even the most important determinant of an institution's risk profile. It would undoubtedly be a good idea to fix these unhelpful incentives. But we should not over-egg the cake by suggesting that capital models actually change bank's behaviour much except at the margin.

Let No Man Rent Asunder

Eric Dinallo, New York’s insurance superintendent, testified today at a hearing of the House Financial Services subcommittee. Both the FT and Bloomberg report various parts of his evidence. The FT first:

[Dinallo] said on Thursday that a government bail-out of troubled bond insurers ”is not planned”. [...]

Mr Dinallo, told lawmakers that finding a solution to allow Ambac, MBIA and others to maintain triple-A credit ratings on which their guarantee business depends was an ”extraordinarily difficult problem”.

Certainly he wins marks for honesty on the latter point. But according to Bloomberg matters got more interesting:

New York regulators may consider splitting bond insurance companies into two businesses to protect municipal debt from losses on subprime mortgage securities.

How could this possibly work? It does not suffice simply to split the liabilities: you have to split the assets too. Presumably any split would have to be equitable to equity holders (and to senior debt holders), so equity would have to be split pari passu with risk. But estimating the economic capital required for a large monoline is about as difficult a problem as we have in financial modeling at the moment, especially given that the muni business diversifies the structured finance business so the standalone capital requirements of the two pieces are more than those of the original whole. Moreover does Dinallo really have the power to do this if shareholders are hostile?

Update. Eliot Spitzer has upped the anti. According to the FT, he has given the bond insurers three to five business days to find fresh capital, or face a potential break-up by state regulators who want to safeguard the municipal bond markets. Oh, and Moody's has downgraded FGIC. So no pressure then. At least we can watch the auction market fall apart while we wait. And join Paul Krugman in speculating on what's next.

Diving in the deep end - the valuation of infrastructure assets

News from Bloomberg that a JPMorgan-led group is buying Southern Water from RBS leads to the question How can market players disagree over the value of infrastructure assets? After all, these are amongst the easiest assets to value: they have stable cashflows in industries with very high barriers to entry and predictable demand. Surely valueing a business like this is little more than an MBA exercise -- so how can RBS and JPM both think they have a good deal?

One of the answers is funding. Whole business securitisation has transformed the market for utility assets as it allows much higher leverage than the traditional public equity/senior debt funding model. If JPM and friends believe that they can squeeze more leverage out of Southern then their equity stake becomes smaller and hence they may be able to get a higher ROE even after paying higher interest expenses.

Another perhaps less remarked upon issue is the assessment of the equity required to support the business. Suppose you want Southern to have a 1% PD. Then you calculate the economic capital required to support the business at a 99% confidence interval. Since cashflow volatility is low - the regulation of the water industry helps matters here - this capital estimate is low and hence your model suggests that a private equity model using double leverage of infrastructure assets is safe. But suppose you want more safety. At a higher confidence interval considerations such as possible alterations in the regulatory environment become significant. The business risk here is that changes in regulation will dramatically change the likely future cashflows of the business: suppose for instance the regulator decides that Southern has to spend more to renovate its pipelines. This risk makes the tails of the return distribution for utility businesses very fat, and hence the capital at a higher confidence interval is much larger. A more cautious owner, then, would assign much more equity and hence need to earn a rather higher return. Thus for instance a cautious RBS and a more aggressive JPM could agree on the all in cost of debt and return distribution yet disagree on the value of the asset. If this were true, RBS could be a seller and JPM a buyer.