Large and Complex Financial Institutions
Encyclopedia
Large and Complex Financial Institutions (LCFI) is a polite term for the bulge bracket
banks. The context is that of systemic risk
, a topic of particular concern to central banks, financial regulators and the Bank for International Settlements
.
Most central bankers have had to deal with a large institution going bust, like Barings did in 1995. The main issue with a retail bank is to ensure that depositors are protected, but the regulators' main concern with a merchant bank
is to ensure that there isn't a damaging loss of confidence in the banking system, and that all the trades, transactions and derivatives
are wound up in an orderly way. If they are not, and all the traders and investors are suddenly forced to meet their obligations or liquidate their positions on the same day, there would be a crisis in the market and many institutions, rather than just the one, would probably go bust or at least suffer substantial losses in a dangerous spiral of falling prices and forced selling.
This is the background story to Long-Term Capital Management
: there are many published articles on why that particular hedge fund
failed, but very few on the systemic risk of all LTCM's counterparties attempting to unwind their positions at once. This is why the Federal Reserve Bank of New York
intervened and organised a $3 billion bailout.
Worse, at least one major European bank had 'hedged' or laid off risk on a significant percentage of its trading book by derivatives trades with LTCM but was a significant investor in LTCM itself. In other words, they had sold on the risks to LTCM, while buying back into them. Even without such errors, there is the worry that positions we think are hedged (effectively 'insured' against adverse market movements) might lose that protection when the counterparty
who sold us those derivatives goes broke. An event which would, by its very nature, occur on the very day the markets go crazy.
Nobody knows what would happen if one of the world's largest banks became severely distressed and was forced to suspend trading, except to say that it would be far worse than Long-Term Capital Management: firstly, because they have ongoing trades with every significant market player, everywhere; secondly, because the sums of money are so much larger. A bulge-bracket bank will, on any given day, have over a ten trillion dollars of open trades on the foreign exchange market
s and in derivatives
.
Fortunately, there are regulatory measures to limit the risk of failure in a Large and Complex Financial Institution. All banks operate under the Basel Capital Accords, set up by the Bank for International Settlements, and their 'Risk' departments enforce "BIS 1" and nowadays the "BIS 2" risk accounting regimes. These are complex sets of rules allowing the bank - and its regulators - to know how much money is at risk in trading positions, no matter how complex, and how much 'regulatory' capital' must be set aside as a buffer against each trade going sour. Further, there can be no concentration of risk with one counterparty, no matter how large they may be.
That last measure - the counterparty risk limit - is every market player's best protection against the failure of a trading partner. And if that player was the only company hit by their trading partner's bankruptcy, or one of a few dozen players caught in the same position, they would all be safe. But we still don't know what will happen if every market player, everywhere and in every market took the same hit. Which is, of course, the perfect description of 'systemic risk'.
Bulge bracket
The bulge bracket comprises the "big banks," the world's largest and most profitable multi-national investment banks.- Technical meaning :The term 'bulge bracket' refers to the first group of investment banks listed on the "tombstone" notifying the public of a financial transaction or deal...
banks. The context is that of systemic risk
Systemic risk
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...
, a topic of particular concern to central banks, financial regulators and the Bank for International Settlements
Bank for International Settlements
The Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...
.
Most central bankers have had to deal with a large institution going bust, like Barings did in 1995. The main issue with a retail bank is to ensure that depositors are protected, but the regulators' main concern with a merchant bank
Merchant bank
A merchant bank is a financial institution which provides capital to companies in the form of share ownership instead of loans. A merchant bank also provides advisory on corporate matters to the firms they lend to....
is to ensure that there isn't a damaging loss of confidence in the banking system, and that all the trades, transactions and derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
are wound up in an orderly way. If they are not, and all the traders and investors are suddenly forced to meet their obligations or liquidate their positions on the same day, there would be a crisis in the market and many institutions, rather than just the one, would probably go bust or at least suffer substantial losses in a dangerous spiral of falling prices and forced selling.
This is the background story to Long-Term Capital Management
Long-Term Capital Management
Long-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
: there are many published articles on why that particular hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
failed, but very few on the systemic risk of all LTCM's counterparties attempting to unwind their positions at once. This is why the Federal Reserve Bank of New York
Federal Reserve Bank of New York
The Federal Reserve Bank of New York is one of the 12 Federal Reserve Banks of the United States. It is located at 33 Liberty Street, New York, NY. It is responsible for the Second District of the Federal Reserve System, which encompasses New York state, the 12 northern counties of New Jersey,...
intervened and organised a $3 billion bailout.
Worse, at least one major European bank had 'hedged' or laid off risk on a significant percentage of its trading book by derivatives trades with LTCM but was a significant investor in LTCM itself. In other words, they had sold on the risks to LTCM, while buying back into them. Even without such errors, there is the worry that positions we think are hedged (effectively 'insured' against adverse market movements) might lose that protection when the counterparty
Counterparty
A counterparty is a legal and financial term. It means a party to a contract. A counterparty is usually the entity with whom one negotiates on a given agreement, and the term can refer to either party or both, depending on context....
who sold us those derivatives goes broke. An event which would, by its very nature, occur on the very day the markets go crazy.
Nobody knows what would happen if one of the world's largest banks became severely distressed and was forced to suspend trading, except to say that it would be far worse than Long-Term Capital Management: firstly, because they have ongoing trades with every significant market player, everywhere; secondly, because the sums of money are so much larger. A bulge-bracket bank will, on any given day, have over a ten trillion dollars of open trades on the foreign exchange market
Foreign exchange market
The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
s and in derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
.
Fortunately, there are regulatory measures to limit the risk of failure in a Large and Complex Financial Institution. All banks operate under the Basel Capital Accords, set up by the Bank for International Settlements, and their 'Risk' departments enforce "BIS 1" and nowadays the "BIS 2" risk accounting regimes. These are complex sets of rules allowing the bank - and its regulators - to know how much money is at risk in trading positions, no matter how complex, and how much 'regulatory' capital' must be set aside as a buffer against each trade going sour. Further, there can be no concentration of risk with one counterparty, no matter how large they may be.
That last measure - the counterparty risk limit - is every market player's best protection against the failure of a trading partner. And if that player was the only company hit by their trading partner's bankruptcy, or one of a few dozen players caught in the same position, they would all be safe. But we still don't know what will happen if every market player, everywhere and in every market took the same hit. Which is, of course, the perfect description of 'systemic risk'.