Eumaeus is dedicated to keeping an eye on the house, but this house has many dwelling places. Kevin Dowd’s ‘Asleep at the Wheel’ took the PRA to task for having dozed off a bit while deciding on how to price a put option, but there are also other regulatory or standard-setting bodies who are directly or indirectly responsible for valuing financial instruments correctly.
The exam question is, given the number of such bodies, why has none of them identified or addressed the problem that some firms apparently cannot value an elementary put option1 correctly?
This post lists some of these bodies and their responsibilities, and raises the question of how we ended up with there being apparently none of them being able answer this elementary valuation question, despite the number of people supposedly keeping an eye on the joint.
- The Prudential Regulation Authority is responsible for the prudential regulation of firms, i.e. primarily protecting the firms’ safety and soundness rather than that of their customers. There are two wrinkles to this mandate. First, article 27 of the Solvency II Directive states that the main objective of supervision is the protection of policy holders, and the PRA is the main custodian of the Directive. Article 28 adds that, notwithstanding, regulators shall ‘duly consider’ the potential impact of their decisions on the stability of the financial systems, but never mind. Second, the PRA has no tools or powers over the statutory balance sheet, i.e. the one that auditors are responsible for, only the regulatory balance sheet. So you end up with the weird situation that, even if the PRA finally decides how a large embedded put option should be valued, the accountants may decide something different, and we could end up with a firm that is insolvent under one measure, but appear viable under another. Which of course is nonsense, but never mind.
- The Financial Conduct Authority is responsible for conduct of business regulation, i.e. protecting the interest of customers. The undervaluation of guarantees affects the interests of both shareholders and policyholders or creditors. Shareholders, because the book value of equity may have been overstated, creditors and policyholders because they rely on the loss absorbing capacity of equity to preserve the reliability of pension or coupon payments. The FCA in theory should have specialists who are able to decide on the pricing of elementary put options, but as far as I know they don’t, since all the technical valuation specialists work at the PRA. A neat approach would have been a single regulator responsible for both prudential and conduct issues, but look what happened to that when we last tried it.
- The Financial Reporting Council ‘regulates auditors, accountants and actuaries’. Most of its work appears to be audits of audits, i.e. checking the work of the firms’ external auditors. If you suspect that this is a box-ticking exercise, or rather ticking the boxes of the people who tick boxes, you would not be far from the truth. In any case, the FRC is not directly responsible for ensuring that simple options are valued correctly, but rather for ensuring the accounting framework and standards are appropriate for valuing them correctly.
- The International Accounting Standards Board (IASB) is an independent body that develops and approves International Financial Reporting Standards (IFRSs). In theory, IFRS should tell us whether a simple option has been valued correctly, but the rules are different depending on whether you are an insurer or not. IFRS 4 is the current standard for insurance contracts, so if the option is not a financial instrument but an insurance contract, ordinary logic may not apply. IFRS 9 is the standard for financial instruments, which does require a derivative to be recognised at ‘fair value’ i.e. on a market consistent basis, but the question is whether that standard actually does apply. You would imagine that instruments which are economically identical should be valued the same even if legally different, but then your imagination would be wrong.
- The Institute of Actuaries is a professional body ‘dedicated to educating, developing and regulating actuaries’. It is also regulated by the Financial Reporting Council, following the Morris Review which, essentially, found that actuaries were pretty useless in dealing with embedded guarantees such as those that brought down The Equitable, but little seems to have changed, despite their protests. The Institute is currently sponsoring a bit of research into the pricing of put options, apparently unaware that Black, Merton and Scholes published the universally recognised method in 1973, an achievement that was subsequently recognised by the award of a Nobel prize in Economics.
- The Serious Fraud Office deals with complex fraud cases, and misvaluation of simple options might conceivably fall within their remit. However, the catch is that fraud has to be deliberate. If someone simply misvalued an option by mistake or through stupidity, there is no intention to mislead. For example, section 90A of FSMA 2000 creates a right of action for investors who have suffered a loss as a result of a misleading statement, but the firm had to have known the statement to be untrue or misleading, see para 3(2). If its experts simply did not know how to value a simple put option, this section does not apply. The section may also apply if the firm ‘was reckless’ about the truth, but the criterion for being reckless is a difficult hurdle. The FCA has a competent employees rule, where competence means ‘having the skills, knowledge and expertise needed to discharge the responsibilities of an employee’s role’, but for insurance companies the relevant role is typically held by an actuary, and we have already seen that actuaries seem to have little competence in these matters.
- The buck stops with the Treasury Committee, whose role is ‘to examine the expenditure, administration and policy of HM Treasury, HM Revenue & Customs, and associated public bodies, including the Bank of England and the Financial Conduct Authority’. To his credit, member John Mann asked for a new session to go into the issue, adding that he thought ‘some financial institutions have pushed the boat out too far with this’, but no new session has been announced so far. To be fair, everyone is on holiday at the moment, so we shall see.
In summary, there are at least seven institutions who are directly or indirectly responsible for making sure that financial instruments – such as simple put options – are valued correctly. Yet none of them is able to decide how to value them correctly, although the rest of us have known how to do this since June 1973. Shouldn’t someone be looking into this? Yes, you say, but the list above includes everyone who should be looking into it, and apparently they aren’t (or are on holiday).
- I emphasise ‘elementary’ and ‘simple’ throughout this post, because that is what a European put option is. If you want ‘difficult’, try pricing a rainbow option. Deputy governor Sam Woods says here that the no-neg guarantee ‘is an enormously complicated financial instrument’, but someone should have told him it really isn’t.