Cap Everything


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This presentation describes a new method for controlling risk and preparing for the next financial crisis which puts a hard-number Maximum Loss Value (effectively a cap) on every financial arrangement.

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Cap Everything

  1. 1. Cap Everything How Financial Institutions Can Prepare for and Manage the Next Crisis Vincent H. O’Neil
  2. 2. The Current Situation <ul><li>Confidence in the world’s financial system has been badly shaken </li></ul><ul><li>Historically-based risk analysis and market-based loss estimates are often rendered next-to-useless in a crisis situation </li></ul><ul><li>The increasing speed and complexity of the modern financial world will continue to generate surprises, issues, and crises </li></ul>
  3. 3. Financial Crises <ul><li>The difference between an issue and a crisis is the inability to solve or contain a problem </li></ul><ul><li>Although dried-up liquidity and frozen markets are often the focus of crisis response, they are usually mere symptoms of a crisis situation </li></ul><ul><li>Uncertainty is what fuels a crisis </li></ul>
  4. 4. Uncertainty is the Key Component <ul><li>Uncertainty causes liquidity to dry up by driving available resources to supposedly safer places </li></ul><ul><li>Uncertainty brings markets to a halt because anyone who can still participate lacks a good idea of what is likely to happen </li></ul><ul><li>Uncertainty thwarts attempts to fix the underlying problem because no one can answer the question, “How bad can this get?” </li></ul>
  5. 5. How Bad Can This Get? <ul><li>The inability to answer this question preserves uncertainty—which can lead to panic </li></ul><ul><li>Some past crises have been resolved because this question could be answered—or answered just enough—to create a solution (Long Term Capital Management, for example) </li></ul><ul><li>In other cases, the inability to answer this question helped doom to effort to solve it (Barings Bank is one example among many others) </li></ul>
  6. 6. <ul><li>Cap every financial arrangement </li></ul><ul><li>This capping will decrease uncertainty by helping a financial institution answer the question “How bad can this get?” in a crisis situation—and before it </li></ul>To Prepare for and Manage the Next Crisis:
  7. 7. <ul><li>Identify all arrangements that already have a cap in place, are eligible for a traditional cap, or are self-capping </li></ul><ul><li>For all arrangements not covered above, build a mechanism into the agreements which cover them so that both the loss and the gain for all parties involved is limited at an acceptable level—thus creating a mutual cap </li></ul>This capping takes place in 2 phases:
  8. 8. <ul><li>Existing: Many financial arrangements self-generate a hard-number maximum loss value that effectively caps them; in other cases a cap has been purchased, sold, or agreed upon </li></ul><ul><li>New: For all arrangements not covered above, a capping mechanism will be worked into the agreement—preferably at no extra cost because the capping will cover all parties involved </li></ul>The two kinds of capping: Existing and New
  9. 9. The Capping Approach Will: <ul><li>Create confidence by reducing uncertainty </li></ul><ul><li>Provide a hard-number Maximum Loss Value for every financial arrangement </li></ul><ul><li>Answer the question, “How bad can this get?” before a crisis develops </li></ul>
  10. 10. Advantages of the Capping Approach <ul><li>No need for heavy government involvement </li></ul><ul><li>No pooled rescue funds </li></ul><ul><li>No new regulation—this method leverages and builds on existing practices </li></ul>
  11. 11. <ul><li>Is measurable and can be modeled </li></ul><ul><li>Can help identify potential problems before they become an issue </li></ul><ul><li>Functions under crisis circumstances (even when unexpected events have occurred) because it covers every arrangement </li></ul>Advantages of the Capping Approach
  12. 12. Capping Isn’t New <ul><li>Many agreements and products already have a specific value identified as the maximum loss </li></ul><ul><li>Many agreements already contain hard-number maximums triggered by specified events </li></ul><ul><li>In this method, every arrangement that doesn’t already have a hard-number Maximum Loss Value will get one </li></ul>
  13. 13. The Goals of Capping <ul><li>Prevent panic by identifying a Maximum Loss Value for every transaction, even in a meltdown </li></ul><ul><li>Develop industry-wide protocols that will in turn build a recognized capping system </li></ul><ul><li>Put the system in place before a crisis so that it can be used as both a warning of approaching trouble and a means of addressing it </li></ul>
  14. 14. The Maximum Loss Value <ul><li>The Maximum Loss Value must be a hard number, though it may change over time based on the product or arrangement in question </li></ul><ul><li>If the Maximum Loss Value isn’t a hard number it will fail to reduce uncertainty in a crisis—which is exactly when the hard number is most needed </li></ul>
  15. 15. The Maximum Loss Value (2) <ul><li>The calculation of the Maximum Loss Value will apply at the lowest level possible (preferably transaction level) to increase the specificity and flexibility of analysis </li></ul><ul><li>Whenever a Maximum Loss Value doesn’t exist, the capping mechanism will have to be created; working this into the agreement covering the arrangement is beneficial to all parties involved </li></ul>
  16. 16. Self-Capping Instruments <ul><li>Many arrangements generate a Maximum Loss Value on their own (for example, the MLV of a fixed-rate loan is the remaining unpaid balance) </li></ul><ul><li>Responsible monitoring of these self-generated MLVs will require detailed analysis of the conditions which would cause these presumably large numbers to become a hazard (for example, when the default rate of the mortgages packaged into a bond begins to climb) </li></ul>
  17. 17. Traditional Caps <ul><li>The traditional cap product (often associated with variable interest rate situations) will continue to be used for its normal purpose </li></ul><ul><li>Other financial arrangements with exposure to market fluctuations will use them as well </li></ul><ul><li>In those instances where such a cap product doesn’t exist, it will have to be created </li></ul>
  18. 18. The New Capping <ul><li>This will require some innovation, as the capping built into these agreements will cover financial arrangements whose values can shift dramatically </li></ul><ul><li>The Maximum Loss Value in these cases must be a hard number, perhaps a multiple of the deal’s original value or a similar figure, allowing for substantial gain or loss while still preventing open-ended exposure situations </li></ul>
  19. 19. The New Capping (2) <ul><li>Building a Maximum Loss Value into the agreement covering these arrangements will limit, but not end, potential profits and potential losses for all parties </li></ul><ul><li>The selling point is: Your profits in these cases won’t make a killing—but your losses won’t kill you either </li></ul>
  20. 20. The New Capping (3) <ul><li>To initiate this new approach, financial institutions could begin building mutual Maximum Loss Values into agreements involving those counterparties with which they do a lot of that kind of business </li></ul><ul><li>Analysis of current netting situations between habitual business partners could help determine the proper capping point for gains and losses limited by this new type of agreement </li></ul>
  21. 21. Hedging and Collateralization <ul><li>Hedging and collateralization will continue to serve their vital role in reducing overall exposure </li></ul><ul><li>However, both of these techniques are vulnerable to disruption in a crisis and should have no involvement in the Maximum Loss Value calculation </li></ul><ul><li>An Adjusted Maximum Loss Value which takes these items into account is acceptable under normal circumstances, but it is likely to promote uncertainty in a crisis and so the Maximum Loss Value should take precedence </li></ul>
  22. 22. Modeling <ul><li>The Maximum Loss Value lends itself to a variety of modeling options which will provide valuable information in both good times and bad </li></ul><ul><li>Instead of potential risk / loss numbers based on historical data, the Maximum Loss Value is a hard number </li></ul>
  23. 23. Standardization <ul><li>Once the Maximum Loss Value is accepted, it could grow to involve most of the entities in the financial world—as well as organizations not traditionally considered financial institutions </li></ul><ul><li>This would lead to a standardization creating a universally-understood Maximum Loss Value for every transaction—which would reduce uncertainty and restore confidence in the financial system </li></ul>
  24. 24. Standardization (2) <ul><li>Once agreement-based capping becomes a generally accepted practice, it could come to replace some of the more traditional capping mechanisms </li></ul><ul><li>This would reduce capping-related expenditures for all parties involved, while still preserving the capping mechanisms which cover those cases where real exposure exists beyond the cap </li></ul>
  25. 25. Conclusion <ul><li>Although the capping involved in this new program will yield benefits in both good times and bad, its greatest asset is that it will allow everyone to credibly answer the question, </li></ul><ul><li>“ How bad can this possibly get?” </li></ul><ul><li>That answer could remove the uncertainty which fuels a crisis—and that alone makes it worth doing. </li></ul>
  26. 26. About the Author <ul><li>Vincent H. O’Neil is an experienced risk manager, an award-winning author, and a trained public speaker. </li></ul><ul><li>He can be contacted through his writing website, or his business email, </li></ul>