Deus Ex Macchiato

From the new Basel consultative document BCBS 245:

Credit protection costs will be considered material when the risk weight on the exposure in the
absence of credit protection would otherwise be greater than 150% at the time the credit protection is bought…

A bank must calculate the present value of material credit protection costs … if such costs have not been recognised in earnings … The present value should be treated as an exposure of the bank and be assigned a 1250% risk weight.

I don’t see that this really helps that much, as you can always mix in ‘good’ stuff to lower the risk weight below 150% and so be out of scope of the rule.

Posted in: Basel, CDS and Negative Basis by David /
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Matt Levine is sad:

Today is a dark day.

His grief is for PAF2, an innovative regulatory arbitrage ahem I mean risk transfer deal whereby CS had their bonus pool write protection on a mezz tranche of derivatives receivables to get CVA capital relief. Or not. This deal probably wouldn’t have worked in most jurisdictions, and even in Switzerland it seems that its days are numbered. As IFRE tells us:

Credit Suisse may be forced to scrap or, at the very least, radically restructure [the deal]

The problem is that CS had to get protection on the senior to get relief, and no one really wanted to write that for what CS wanted to pay, so CS had to reduce the liquidity risk of the senior CDS by agreeing that if there was ever a payment on the senior, they would lend the counterparty the money to make it. So if the world goes to hell and CS lose a lot of money on counterparty credit risk – really* a lot of money – then they make a claim on the senior CDS which CS’s counterparty pays with money they have just borrowed from CS**. Um. Is that risk transfer?

As Matt says, Basel says no. Hence the problem.

Now, unlike Matt, I’m not sad, because this deal should never have worked. Regulatory arb that finds a clever way to transfer risk at the right price in order to exploit mis-designed rules is fair enough; reg arb that purports to transfer risk but doesn’t seems to me to be basically an arb not of the rules but of the regulator’s understanding of the trade. Unless, that is, they understood it but didn’t see the problem, in which case we have a bigger issue.

*Matt seems convinced that the senior attachment point was so high there was practically zero risk in the senior; I haven’t seen the trade details so I don’t know, but I will say that wrong way and concentrated sovereign risks can be significant in derivatives receivable securitisation structures, so one would want to be rather careful about the modelling before asserting something like that.

**And which, it appears, they can ‘pay back’ – in a very loose sense – by assigning the CDS back to CS.

Posted in: Basel, CDS and Negative Basis, Credit, Regulation by David /
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The FT tells us

Lord Turner told the Commission on Banking Standards that new banks would be allowed to start up with core capital equal to as little as 4.5 per cent of their assets, adjusted for risk.

The Prudential Regulation Authority, which takes over bank supervision from the FSA in April, would give new lenders some time – perhaps three years – to get their core capital up to 7 per cent. Their management would not be allowed to pay bonuses or dividends until they hit the higher threshold.

This is of course entirely consistent with Basel 3: 4.5% is the minimum, and between 4.5 and 7 you can’t pay divys or bonuses. So the UK is using all the flexibility that Basel gives them.

What really brings this into focus, though, is a passage later in the same story:

Small banks and new entrants must use a residential mortgage risk weight of 35 per cent – the key input for capital requirements – but some UK banks that use models have cut that number to 5 per cent

In other words, that is a 4.5% capital ratio based on standardised RWAs, not on IRB RWAs. The smaller or newer guys are not getting absolutely lower capital, just a little compensation for not having IRB models (or the history to prove that they are well-calibrated). As the EBA points out, IRB models can be manipulated to produce rather low capital requirements, making a 7% (or 10%) ratio easy to achieve.

The ‘top down’ analysis conducted using the existing supervisory reporting data from 89 European banks across 16 countries confirms material differences between banks in the calculation of the Global Charge (GC) defined as the sum of RWAs (unexpected losses) and the expected losses (EL).

The analysis conducted so far suggests that:

- 50% of the differences in terms of GC between banks mainly stem from the approach for computing RWAs in use (standardised vs IRB) as well as from the composition of each bank’s loan portfolio. In other words, these are differences that relate to the structure of a bank’s balance sheet as well as to its reliance on the different regulatory approaches for assessing and measuring risks (referred in the report as A-type differences).

- The remaining 50% stem from the IRB risk parameters applied thus reflecting each bank’s specific portfolio and risk management practices.

I wonder how much of this IRB-driven variation would go away if there was a 15% RW floor on mortgages.

Posted in: Basel, Mortgages, Regulation by David /
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The Swiss are imposing a 1% countercyclical buffer due to real estate market overheating. This is probably sensible. But it does come in the same week that I read

There is little evidence that the credit to GDP gap, the ratio of credit to GDP or credit growth are factors affecting the incidence of crises in OECD countries

In other words, the key factor that Basel III suggests should be used to determine whether to impose a countercyclical buffer is of no use as a crisis predictor. What is, pace Switzerland, is house price growth.

Posted in: Basel, Mortgages by David /
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I want to distinguish two issues, as a prelude to another post on central capital calculations.

First, there’s behavior. If everyone, or many folk, do the same thing, then you get herding and the possibility of phase changes. In financial stability terms that’s bad. You want people to do different things, as a diverse ecology of financial institutions is more robust than a mono-culture.

Second, there are standards, like regulatory capital. You want them to be simple and uniformly implemented, because that creates investor trust. There is a massive information asymmetry between bank managers and bank investors, and regulatory capital ratios help to level the playing field. It doesn’t matter if they don’t measure risk very well because you care much more about false negatives (well capitalised bank is not solvent) than false positives (solvent bank does not pass regulatory standard).

Thus, recent objections to my proposal to centralise model-based capital calculations are wrong because they confuse the first issue with the second. SWP says:

We want to diversify model risk, not concentrate it. Centralized calculation concentrates it. I actually see an evolutionary benefit in the wide range of model risk weights that DEM bewails. That represents a diverse ecosystem of entities with divergent views that is less vulnerable to a single shock. Yeah, that shock will crater some banks, but not all of them. When I think of any-ANY-centralized calculation, I think of the Socialist Calculation Debate. I also think of monocultures that are dangerously vulnerable-systemically vulnerable-to a single shock. Think of the devastation that smallpox wreaked on native American populations. A single shock can crater everybody all at once.

That would be true if all banks did the same thing, but there is no requirement, or even strong incentive, for that. All I am asking is that they all, in their diverse ways, meet a simple standard: that centrally calculated market risk RWAs are less than the amount of capital they set aside for market risk.

Will this central calculation be wrong? Yes, clearly so. Will it be differently wrong for different banks? No, it will be wrong in the same way for everyone. But does that introduce an incentive for all banks to behave the same way? No, it doesn’t. This is partly because many banks don’t care about market risk RWAs (think Wells Fargo or Lloyds) and partly because even the ones that do don’t base their behaviour simply on what is cheapest in capital terms.

In short, letting banks use their own models for market risk RWA calculation reduces investor trust without adding much if any robustness. Root them out, cut costs*, and set a standard that is believable and whose information content is easily understood.

*Which are enormous.

Posted in: Basel, Regulation by David /
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The recent New York Times article on the Basel Committee might prompt one to think that a rapid end to this most international of collaborations is in prospect — or at least that a prominent country or two might leave the big Basel tent. I suggest the matter is more subtle.

First, in all but name, countries have already abandoned Basel. The US has been famously tardy in its implementation of Basel 2, and never got around to Basel 2.5 before Dodd Frank made it impossible — indeed, illegal — for it to be implemented. There is a permanent statutory limit on the FED’s ability to alter US bank capital regulations via the Collins amendment to Dodd Frank (although exactly what that means is hotly debated).

Meanwhile almost every jurisdiction you can think of (Switzerland, via the Swiss finish; the EU with Liikanen, the definition of capital, &c; the UK with Vickers; Japan, by implementing loan loss provision standards with all the rigour of a drunk man trying to write his name on a grain of rice) has modified or proposed modifying Basel standards to suit their convenience. (Some of those proposals go further than Basel, which of course is fine in terms of prudence, but it rather wrecks the Basel Accord = global standard argument.)

My point is not that this is good (or bad). It is simply that Basel may be suffering a slow death, an unannounced death by a thousand variances. No country is going to announce that it is resigning from the Basel Committee: no country will publicly dissent from a major Accord. But many will implement piecemeal, late, or `with local characteristics’. The SIG might write a nasty report, but that will, largely, be that. The playing field was never level, but now it is getting slowly lumpier.

The NYT article exorts the US to go it alone, abandoning Basel. My question is simply how would you know that this advice had not already been taken?

Posted in: Basel by David /
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The new revisions to the Basel III LCR do not, of course, water it down to homeopathic quantities, but I love the phrase so much I wanted to use it nonetheless.

Basel proposes:

• the definition of high quality liquid assets (HQLA) has been expanded to include lower-rated corporate bonds (A+ to BBB-);
• certain equities with 50% haircut
• as well as certain RMBS rated AA or higher with 25% haircuts.
• The aggregate of these additional assets are subject toa limit of 15% of the HQLA.

The Basel Committee has also agreed to a timetable for phase-in of the new standard. Banks’ LCR will need to reach 60% in 2015, increasing by10% p.a. until 2019, instead of a 100% requirement in 2015.

My snap judgement is that this can probably be met by most banks in the current liquidity environment. Whether it will act as a constraint later is less clear.

Posted in: Basel, Liquidity and liquidity risk by David /
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First, from Bloomberg:

Countries may face sanctions if they fail to implement new rules aimed at safeguarding the global banking system from another financial crisis, a senior Mexican finance official said… Juan Manuel Valle, head of banking supervision at the Mexican Treasury, said no country had suggested a delay but any that failed to meet the deadline would face pressure from their peers.

“For the ones that don’t have regulations in place in January, the question will be, what kind of punishment will they face?”… Valle said he would think twice about being overly tough on timing if he were in charge.

“If you ask me, I think we exaggerated with what we did (on the Basel timetable) and we should think again about whether we want to support our financial institutions more to finance growth and accelerate the exit from the crisis … and lengthen the period of adjustment towards the new levels.”

Then a day later, the FED, OCC, and FDIC say:

The U.S. federal banking agencies issued three notices of proposed rulemaking in June that would revise and replace the current regulatory capital rules. The proposals suggested an effective date of January 1, 2013. Many industry participants have expressed concern that they may be subject to a final regulatory capital rule on January 1, 2013, without sufficient time to understand the rule or to make necessary systems changes.

In light of the volume of comments received and the wide range of views expressed during the comment period, the agencies do not expect that any of the proposed rules would become effective on January 1, 2013.

So, place your bets: US Basel III implementation in less than a year; a year or more; or never? And for extra credit, will there be any consequences at all from Basel for this delay?

Posted in: Basel by David /
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The 14 big OTC dealers are becoming, well, at least 13 and likely 12. UBS is the certain loss, after its announcement of 10,000 job losses and a radical cut of its investment bank. In future UBS IB will focus on advisory, equities trading & FX. The upside, Citi research point out, is ‘potential c. CHF 11B (c. 23% of current market capitalization) of capital release’ – capital which is currently ‘generating sub-par returns’. Perhaps the good gentlemen of Basel, less than an hour on the train from UBS’s headquarters in Zurich, might care to contemplate the fruits of their radical increases in capital requirements for trading activities. Is greater concentration in FICC really a good thing for financial stability?

Update. Bloomberg reports:

The world’s biggest investment banks, which also include JPMorgan Chase and Citigroup, are facing less competition for business after UBS became the latest of Europe’s banks to shrink its operations, saying it will reduce fixed- income trading. RBS, which said in January it would close or sell equity and mergers advisory divisions, was also among victims as Europe’s debt crisis roiled markets and tighter capital rules made some businesses unprofitable.

The 10 biggest investment banks shared $22 billion of fixed income, currency and commodities sales and trading revenue in the second quarter, according to data compiled by Bloomberg Industries. JPMorgan ranked first, followed by Barclays, Citigroup and Deutsche Bank while UBS came in at second to last, the data show…

UBS may be realizing it can’t compete in products such as fixed income trading, which lenders such as JPMorgan and Deutsche Bank already dominate, said Christopher Wheeler, an analyst at Mediobanca SpA in London.

Posted in: Basel, Markets by David /
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We might have speeded up, but that worthy prize winner the EU is delaying. Twice.

Bloomberg one:

The head of the European Central Bank said that common banking supervision in the euro area may not become operational before 2014 even if legislation is in place at the beginning of next year.

And two:

The European Union may consider pushing back when lenders need to start phasing in tougher Basel bank-capital rules by as much as a year after warnings that pressing ahead with the original timetable may drive up costs, according to three people familiar with the talks… European banks have said the original start date is “wholly unreasonable” given that the final details of the EU’s implementation of the measures is still unknown.

1/1/2014 would make a lot of sense for both of these.

Posted in: Basel, Eurocrisis, Regulation by David /
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The EU is understandably irritated by the new Basel report on the state of their Basel 3 implementation. (HT FT Alphaville.) There are three reports, on the EU, US and Japan, but the EU one contains the most criticism. This is peeving M. Barnier and his colleagues in the Commission who opine:

Notably, when comparing again the three reports, it turns out that the Basel Committee’s assessors are much less concerned if in another jurisdiction, all internationally active banks are still subject to the outdated Basel 1 framework and this leads to around 20% lower capital requirements overall according to local supervisors.

One can see their point. While the draft EU directive is non-compliant with Basel in the definition of capital and there is a loophole which allows banks to assume that their sovereign debt holdings are risk-free, at least the EU — unlike the US — has actually implemented Basel 2. (Whether that is a good idea or not is another discussion entirely.)

Posted in: Basel by David /
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FSA says:

The draft European Union legislation to update the capital requirements framework, known as CRD IV1, has been under discussion between the European Parliament, European Commission and Council of Ministers. These discussions originally aimed to finalise an agreed position by end June 2012 enabling adoption by the European Parliament plenary in early July 2012.

Following the delay of the Parliament’s plenary vote and the recent statement by the Rapporteur of the European Parliament2 and the discussion of the Council of Economic and Finance Ministers3, it is clear the legislation will not be adopted earlier than autumn 2012.

My guess is that it will be at least 2014 before CRD IV hits.

Posted in: Basel, Regulation by David /
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My response to the fundamental review of the trading book is here.

Posted in: Basel, Risk Management by David /
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From BCBS 228, Basel III counterparty credit risk – Frequently asked questions :

How should purchased credit derivative protection against a banking book exposure that is subject to the double default framework or the substitution approach be treated in the context of the CVA capital charge?

Purchased credit derivative protection against a banking book exposure that is subject to the double default framework or the substitution approach and where the banking book exposure itself is not subject to the CVA charge, will also not enter the CVA charge. This purchased credit derivative protection may not be recognised as hedge for any other exposure.

So, let’s get this right. You have a banking booking position, oh say some RMBS, just to pick a random example. You buy CDS on it from oh, say MBIA. MBIA’s credit spread goes to the moon during a crisis, but there is no CVA charge just because it is in the banking book? (There will be a higher default risk charge, of course, but that isn’t the point.) Interesting…

Posted in: Basel, Credit by David /
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Mario Draghi said:

The interbank market is not functioning, because for any bank in the world the current liquidity regulations make – to lend to other banks or borrow from other banks – a money losing proposition. So … regulation has to be recalibrated completely.

Posted in: Basel, Liquidity and liquidity risk by David /
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A slightly expanded version of this post on the JPMorgan losses, accounting, and CRM models is up on FT alphaville here.

Posted in: Accounting, Basel, Regulation, Writedown by David /
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In the theory of programming languages, you learn that parsing is a syntactical operation that doesn’t require any analysis of meaning. Therefore I shouldn’t complain that dealbook’s recent post, Parsing Jamie Dimon’s Testimony, doesn’t inform as, really, it doesn’t promise that it will. It does, though, set up enough clues that you can guess a little more of the JPMorgan story.

Here are the key pieces.

• Dimon said:

  In December 2011, as part of a firmwide effort in anticipation of new Basel capital requirements, we instructed CIO to reduce risk-weighted assets and associated risk. To achieve this in the synthetic credit portfolio, the CIO could have simply reduced its existing positions; instead, starting in mid-January, it embarked on a complex strategy that entailed adding positions that it believed would offset the existing ones. This strategy, however, ended up creating a portfolio that was larger and ultimately resulted in even more complex and hard-to-manage risks.

• The new Basel capital requirements will require a bank like JPM to calculate capital for the correlation trading portfolio using a new type of internal model, a CRM or comprehensive risk model.
• CRM models operate on a portfolio basis, and will recognise partial risk hedging. Therefore if you have a position and want to reduce capital somewhat but keep some of the risk, you can do that by ‘adding positions that [you believe]would offset the existing ones’.
• CRM models do not include investment positions, so if the broad theory that JPM was long deposits, long corporate credit risk to invest then, then using synthetic credit positions to protect the crash risk of the bonds is correct, the CRM model would only have included the last of these positions. Thus JPM would have had both an accounting and a capital mismatch: depos and bonds accural accounted and capitalized in the banking book; protection fair valued and CRM-modelled in the trading book.
• It seems a reasonable theory then that JPM was trying to address this mismatch by modifying its positions to reduce future regulatory capital (and accounting volatility) while still keeping their essential nature as crash hedges. The modifications introduced extra risk which caused the $2B hole.

That’s my current best guess; I await Jamie’s congressional testimony with interest.

Posted in: Basel, Risk Management, Writedown by David /
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First, the FED’s proposals on implementing parts of Basel 2, 2.5 and 3, here.

Second, Barroso is pushing for EU banking union, but Britain is demanding a safeword. According to the FT:

The plan, which would also include an EU-wide deposit guarantee scheme and a rescue fund paid for by levies on financial institutions, could be achieved by next year and without changes in the bloc’s existing treaties, Mr Barroso said.

“I think now we have conditions to go further that, frankly, we did not have before,” he said. “There is now a much clearer awareness among European member states about the need to go further in terms of integration, especially in the euro area. This is one of the lessons of the crisis.”

This would also involve a single pan-European banking supervisor, Europe-wide deposit protection and bank resolution schemes, and Frankfurt being renamed Finanzzentrum der Welt. Actually I might have made that last part up, but still, this is huge.

Posted in: Basel, Regulation by David /
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This is my initial reaction to the fundamental review of the trading book. I’ll set out what is in the FRTB in roman, then my reaction in italics. In many cases I’ll quote the Basel document for the former.

Preamble

First the good news. The Committee recognises that the Basel 2.5 revisions did not fully address the shortcomings of the market risk framework.

• The framework lacks coherence;
• The boundary issue (between the trading book and the banking book) has not been fully addressed;
• Problems remain unaddressed in the standardized market risk rules.

Basel 2.5 was, in my view, a sticking plaster, designed to ameliorate the immediate problem – and to dramatically increase the capital required for the trading book – but not to provide a coherent solution. The FRTB is an attempt at that solution.

The trading book/banking book boundary

The boundary is an issue in that some things were put in the trading book pre crisis which turned out to be illiquid. Trading book rules designed to capitalise short term market risk assigned too little capital to these positions. Therefore the committee wishes to strengthen the boundary criteria.

The Committee is consulting on two possible solutions to the boundary:

• A “Trading evidence”-based boundary where instruments will be admitted to the trading book provided that the bank has trading intent plus proven ability to execute that intent; or
• A “Valuation”-based boundary where the trading book will be defined by those items which are fair-value accounted.

To a certain extent, if the Committee addresses illiquidity as proposed below, then boundary arbitrage might either go away or, more likely, go the other way; the banking book might be cheaper than the trading book post FRTB. In any case, philosophically, the market risk rules should capitalise variation in fair value, so the second approach is clearly more coherent than the first (which would permit fair value variation to go uncapitalised in the banking book).

Stressed calibration

The Committee, understandably, wants:

• to ensure that regulatory capital is sufficient in periods of significant market stress; and
• to reduce the cyclicality of market risk capital charges.

Calibrating the capital framework to a period of stress helps to achieve both of these objectives.

I agree, but the devil is in the stress here. What we don’t want is banks all having book that would be very robust if the last crisis happened again, but which are all vulnerable to the next one. That’s the problem with uniform capital rules; they encourage herding.

Moving from value-at-risk to expected shortfall

ES will be used instead of VAR in models-based approaches.

While this aspect of the FRTB has received a lot of attention, it is not a massive change. Banks will be able to use their existing VAR infrastructure to calculate ES, and ES charges – while larger than VAR – should behave much like a stressed VAR.

A comprehensive incorporation of the risk of market illiquidity

This, in contrast, is a big change. It will, if implemented, force firms to take asset liquidity a lot more seriously.

• The framework will incorporate an assessment of market liquidity for regulatory capital purposes. Banks’ exposures would be assigned into five liquidity horizon categories, ranging from 10 days to one year.
• Capital will be based on the assigned liquidity horizon.
• There will also be capital add-ons for jumps in liquidity premia, which would apply only if certain criteria were met. These criteria would seek to identify the set of instruments that could become particularly illiquid, but where the market risk metric, even with extended liquidity horizons, would not sufficiently capture the risk to solvency from large fluctuations in liquidity premia.
• The Committee is consulting on two possible options for incorporating the
  “endogenous” aspect of market liquidity. (Endogenous liquidity is the component that relates to bank-specific portfolio characteristics, such as particularly large or concentrated exposures relative to the market.) The main approach under consideration by the Committee to incorporate this risk would be further extension of liquidity horizons; an alternative could be application of prudent valuation adjustments specifically targeted to account for endogenous liquidity.

Let’s suppose that the committee is broadly comfortable with the overall level of capital assigned to the trading book after the Basel 2.5 changes. That’s an assumption, but a reasonable one I think, as B2.5 was a quick fix designed to get the level of capital roughly right. In this case, clearly highly liquid areas (FX, most cash equities, some rates) will benefit from these proposed changes, while less liquid ones (most junk credit, most ABS) will suffer.

Treatment of hedging and diversification

The Committee is proposing to more closely align the treatment of hedging and
diversification between the standard rules and internal models.

Notice that this cuts two ways: reducing the diversification (and perhaps hedging) benefits for banks with models permisssions, while increasing them for standard rules banks.

The Committee proposes

• Constraining diversification benefits in the internal models-based approach to address the Committee’s concerns that such models may significantly overestimate portfolio diversification benefits that do not materialise in times of stress.
• Supervisor imposed (stressed) correlations will be a floor to diversification benefit within the internal models regime; and
• Revisions to the standardised approach that will enhance its risk sensitivity.

The hard part here will be improving the standard rules. There is very little detail from the Committee on this aspect.

Relationship between internal models-based and standardised approaches

The Committee considers the current regulatory capital framework for the trading book to have become too reliant on banks’ internal models that reflect a private view of risk. In addition, the potential for very large differences between standardised and internal models-based capital requirements for a given portfolio is a major level playing field concern and can also leave supervisors without a credible option of removing model permission when model performance is poor. To strengthen the relationship between the models-based and standardised approaches the Committee is consulting on three proposals:

• First, establishing a closer link between the calibration of the two approaches;
• Second, requiring mandatory calculation of the standardised approach by all banks;
  and
• Third, considering the merits of introducing the standardised approach as a floor or surcharge to the models-based approach.

This follows a general theme of backstopping models-based capital requirements by cruder, deliberately less risks sensitive calculations (in case the latter are wrong). Again, though, the devil is in the details; how will the Committee make the calibration ‘closer’ and how will it ensure that the two approaches do not drift too far apart?

Revised models-based approach

The Committee proposes to

• strengthen requirements for defining the scope of portfolios that will be eligible for internal models treatment; and
• strengthen the internal model standards to ensure that the output of such models reflects the full extent of trading book risk that is relevant from a regulatory capital perspective.

A key tool here will be desk-level models permission, based on

• P/L attribution and
• Backtesting

In other words, a bank won’t have models permission or not (a binary thing), but rather will have permission for some desks but not others. Even the most sophisticated banks may struggle to meet the standards to use models on some exotics businesses, for instance. While this approach makes sense, it is vulnerable to supervisory arbitrage, i.e. it will be vital that individual national supervisors interpret these criteria equitably.

Revised standardised approach

Two suggestions are given:

• Partial risk factor approach: Instruments that exhibit similar risk characteristics would be grouped in buckets and Committee-specified risk weights would be applied to their market value.
• Fuller risk factor approach: map instruments to a set of prescribed regulatory risk factors to which shocks would be applied to calculate a capital charge for the individual risk factors. The bank would have to use a pricing model (likely its own) to determine the size of the risk positions for each instrument with respect to the applicable risk factors. Hedging would be recognised for more “systematic” risk factors at the risk factor level. The capital charge would be generated by subjecting the overall risk positions to a simplified regulatory aggregation algorithm.

The appropriate treatment of credit risk within the market risk framework

Currently the market risk framework capitalises jump-to-default (and ratings migration) risk via IRC models, while charging for credit spread risk in VAR.

The Committee is consulting on whether, under a future framework, there should

• continue to be a separate model for default and migration risk in the trading book,
• or a single model.

Clearly consistency between the treatment of the same risk in the banking and trading books is to be desired.

Areas outside the scope of these proposals

• Interest rate risk in the banking book. The Committee intends to consider the timing and scope of further work in this area later in 2012.
• Capital for CVA risk.

IRRBB is something the FSA believes should be capitalized, but where it faces strong opposition from other supervisors. The industry is unhappy with the CVA proposals in Basel 3, and in particular with their poor treatment of market risk hedges to the CVA, but the Committee is not proposing to address this in the FRTB.

Summary

Overall, I find these proposals fairly sensible, if lacking in detail in a number of key areas. The thinking on liquidity, in particular, is valuable and welcome. The trading book/banking book boundary, while a flaw in the current regime, is in practice not a major vulnerability, and so it is good that the Committee is not suggesting anything too radical here. Expected shortfall is clearly a more stable risk measure than VAR, so again moving to this approach represents a sensible incremental improvement. A lot remains to be done though, especially developing the standard rules proposals.

Posted in: Basel by David /
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…is out. First reaction is that it isn’t bad. A more detailed response will follow shortly.

Posted in: Basel by David /
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A recent post by the Streetwise Professor made me wonder: how risk sensitive do we want capital requirements to be? Or to try to be?

Let me explain.

In the 1980s and 90s, it was a tenet of both regulators and banks that capital requirements should be risk sensitive. More risk requires more capital. That’s a good thing, right?

Well, yes and no. There are (at least) four problems.

1. Capital rules are always behind, and sometimes far behind, industry progress in risk measurement. The goal cannot be attained.
2. Relative risk equality is important, by which I mean that the same risk taken in different ways should attract the same capital charge. The Basel capital rules (increasingly) don’t meet this basic goal. Let’s fix this before we try and figure out the harder task of charging appropriately for different risks.
3. Risk measures are procyclical. That’s an inherent property of a good risk measure. There is a strong argument against procyclical capital rules.
4. Risk models can turn out to be flawed, or mis-calibrated. Therefore there needs to be some kind of backstop to prevent the massive growth of products which look low risk according to a (as it will turn out) flawed methodology.

Given this, I am tempted to ask (but not – notice – answer) a difficult question.

Is the task of trying to create a risk-sensitive capital framework worth attempting, given that it is not achievable, and failure necessarily leads to arbitrage?

Your thoughts, as always, are welcome.

Posted in: Basel, Regulation by David /
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In the first three parts, we saw that the new Basel rules for the trading book should have the following elements:

1. Capital to support losses in a credit crisis, where spreads go out, volatility rises, equity prices fall, and rates either go up or down; plus
2. Capital to support losses due to idiosyncractic risk; plus
3. Capital to convince the markets that the bank is still solvent after these two classes of loss.
4. We also need a global model benchmarking regime to provide confidence that the process is not being gamed.

Thus total capital = 2 x (stress capital + idiosyncractic capital). The 2 x being there to account for item 3.

We saw that idiosyncractic risk is by definition uncorrelated, so idiosyncractic capital is the square root of the sum over all risk factors of F x daily stressed volatility of risk factor x number of days to hedge the bank’s position in the risk factor in a stressed market. F is a prudence factor needed to obtain the right degree of confidence: for instance, F = 2.33 would give you 99% confidence under a normality assumptions; it would be better to calibrate F using a fat tailed model, which would probably give you 6 or 8 or something like that.

Posted in: Basel, Regulation by David /
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This is another in my continuing series on the upcoming Basel fundamental review of the trading book.

Today I want to talk about models, and consistency. Now while I have a lot of sympathy with A foolish consistency is the hobgoblin of little minds, it has to be admitted that perceived lack of consistency between different banks’ capital models has caused a lot of comment which has damaged the reputation of the regulatory process. I say ‘perceived’ because few people really understand the materiality of the differences between different banks’ models. That has not stopped commentators from Jamie Dimon to Andy Haldane suggesting that there is too much room for banks to reduce capital by changing their models, and too little supervisory consistency, though, and I can see their point.

All the same, there’s no getting away from models. Only a model can hope to measure risk accurately. Standard rules – like capital = 8% of notional – are just bad models.

So what should we do?

The answer is that the fundamental review of the trading book should introduce a benchmark portfolio regime. All systemically important banks should be required to calculate capital using their own models on a number of standard portfolios every quarter. These portfolios would be updated regularly. Bank results would be compared, and those that were low would have higher capital multipliers imposed. Anyone who was too far out would not be permitted to use their model for that asset class at all. The process could be run by the financial stability institute in Basel, and results should be public. That would certainly enhance confidence in the financial system.

(The cynical among you might note it would also generate wonderful opportunities for folks like, ahem, me, to help banks ‘improve’ their models before the process started. That might be true. But just because something would be a consulting goldmine doesn’t make it bad. Does it?)

Posted in: Basel, Regulation by David /
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Yesterday we saw that a major plank of the new Basel trading book regime should be capital against a large systemic shock aka a credit crisis. Today we will look at another element of capital requirements: that for idiosyncratic risk.

Now, if we are truely capturing idiosyncractic risk with no systemic component – which is a reasonable assumption as we got the systemic stuff yesterday – we can make a zero correlation assumption. The total capital requirement is then just the root-mean-square of the capital requirements for each individual risk.

What’s the capital requirement for each individual risk? Well that depends on two things: the volatility of returns in the risk factor, and the holding period, i.e. how long we are on risk for. The first is easy to estimate – just use a long run historical average volatilty. (Again, this is not imprudent as we captured high volatility periods in our systemic risk capital in the prior step).

The second is harder as it depends on how long it would take us to hedge the risk. For FX, that is probably minutes. For an illiquid ABS, it may be months. So the shock we apply should depend on the time to hedge, and that in turn should depend on (a) the size of the position relative to normal market size and (b) the liquidity of the risk factor in stressed conditions. In short, large positions relative to stressed market liquidity should attract a lot more capital than smaller, easily hedged ones.

Posted in: Basel, Regulation by David /
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The long-promised feast, the Basel fundamental review of the capital rules for the trading book, will be upon us soon. (Probably.) So what should be in it?

First note that the current Basel trading book rules are an awful mess. VAR plus stressed VAR plus IRC plus CRM plus securitisation carve out plus counterparty credit risk (default and CVA charges). If it reminds you of Vicky Pollard, you wouldn’t be the first.

So, what should the fundamental reviewers do? After all, they do have the mandate to clear up this mess. I want to say a reasonable amount about this, so I am going to split this discussion over several posts. Today though I want say a little something about simplicity.

Clearly the current capital rules lack simplicity. They feel as if they were assembled piecemeal, with every new risk that some supervisor became concerned about generating a new charge. There is no attempt at coherence, lots of double counting of the same risk, and little focus on what makes banks fail.

First, a design principle. It is this: banks should hold enough capital such that they can withstand a very substantial shock and continue to fund themselves.

What kinds of very substantial shocks do we see in the financial system? Simple. Credit shocks. Credit spreads go out, equity prices fall, volatilities go up. Depending on the shock, interest rates either rise (an inflationary crisis, such as 1973) or fall (as in the 2008 crisis). FX moves some, and you can’t really predict which way. A modest number of scenarios can cover all of the relevant possibilities.

The most important element of trading book capital rules, then, is that they should properly capitalize the risk of a credit shock. Few other risks in the trading book are likely to bring a big sophisticated bank down, but this one can. So keep the rules simple, and ensure that they treat the important risk prudently.

Posted in: Basel, Regulation by David /
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When the RMMG (as it then was) issued the CVA capital rules in Basel 3, I said that they would lead to a number of capital arbitrage deals. Street talk was that the Swiss were first off the blocks; now we learn from Euroweek (HT FT Alphaville) of a deal by RBS:

Royal Bank of Scotland is in the market with a highly innovative capital relief trade, dubbed Score 2011-1, securitising a $2bn book of credit counterparty risk.

There are some challenges to getting both default risk and CVA charge capital relief in a securitization structure, but they aren’t insurmountable. I predict 2012 will see a goodly number more such deals.

Posted in: Basel, Credit, Derivatives, Hedging and Convexity by David /
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Dealbreaker picks up on some interesting comments from Goldman’s Viniar about allocating regulatory capital to businesses:

As far as how we’re charging the desks, that’s a little bit of a complicated question. And we’re working through that now, and it — there’s no one-size-fits-all yet. And we have to be careful. As you know, Basel III does not kick in for quite a while, and quite a bit of what we do is very short dated. And so we don’t want to charge desks on a Basel III basis, have them turn down profitable opportunities that would be long gone from our balance sheet long before Basel III ever kicks in. So we’re really taking into consideration the tenor of what we do and trying to figure out what capital regime we’re going to be under. And it’s still — I would say, we’re going through a transition process here.

This makes sense. If you do a one year trade now, Basel III won’t touch it, so charging for Basel III capital is crazy. But if you do a twenty year trade, it probably will be affected by whatever ends up being implemented. Goldman being a US firm has less certainty here than many, as the US is notoriously slow at implemented Basel Accords, and quite likely when it does get around to doing something to implement a subtly different set of rules. So somehow a US bank like Goldman has to design a regulatory capital allocation mechanism that doesn’t discourage short term trades that are profitable under the current rules, but also doesn’t load up the balance sheet with long term ones that have an unattractive ROE under whatever the US version of Basel III ends up being. Tricky.

Posted in: Basel, Cost Benefit Analysis by David /
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Switzerland has a freedom of information law, as do some of the Cantons. Now, the national law probably doesn’t apply to a transnational entity like the BIS, and it is anyway little used, but if anyone feels like making a nuisance of themselves, how about writing to the secretary of the Basel committee and asking him to make the Basel Committee membership, meeting schedule and minutes public? Then, when that does not work (as I am pretty sure it won’t), try the Swiss information commissioner.

Posted in: Basel by David /
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Risk Management Australia has a nice history of the Basel Accord process from Pat McConnell here. As well as describing how the Accords have evolved, he makes some good points about Basel’s responsiveness. My favourite section of the post describes what Basel did and didn’t do in the years around the crisis:

By the time that Basel II was finally implemented, in 2008, it was already too late. It was overtaken by the Global Financial Crisis (GFC), which was exactly the type of credit related calamity that Basel was meant to prevent. The Basel capital regime failed as supposedly well-capitalised banks around the world had to have injections of capital from taxpayers, sovereign wealth funds and investors, such as Warren Buffett. All sorts of risks that had been excluded from Basel rules, such as liquidity risks, had torpedoed some of the largest banks in the world, costing taxpayers trillions.

Basel was not responsible for the GFC, but it was as useful as an umbrella in a hurricane. During the crisis, when it should have been in the forefront of efforts to tackle the mayhem, the Basel Committee was ‘missing in action’, meekly trying to grab attention from the sidelines while bodies such as the G20 and the IMF rolled up their sleeves to tackle the problems…

When the hubbub died down, the Basel Committee did what it did best, which is to issue new rules to ‘fight the last war’. In 2010, the Committee unveiled Basel III, which in itself is not an unreasonable set of rules to force banks to maintain capital to cover liquidity risks. However, Basel III does not address some of the key root causes of the GFC, such as the problem of what to do with ‘too big to fail’ (TBTF) banks nor, given its reliance on the ratings of the rating agencies disgraced in the GFC, how to estimate the probabilities of credit default?

McConnell suggests that some independent oversight of the Basel process would help, perhaps from the IMF. It would. So too, would a Basel arbitrage group that looked at the proposed rules and figured out how banks would react to them. (I suggested this to both Howard Davies and Nout Wellink on separate occasions in the early 2000s, and got nothing more than two dirty looks for my trouble.)

Fundamentally though, a multinational process with 30+ participants and governance that is about as transparent as FIFA’s* cannot be responsive. The Basel process is not fit for purpose and it is time to stop pretending that it is. We need to escape the Basel doom loop.

*If you think I am joking, consider this. There is no public list of Basel Committee members. (You can find out which countries are represented, but not who goes to the meetings.) There are no published agendas for the meetings, which are all secret. Most of the real discussion happens in working groups: membership of these is secret, as are their meeting dates and topics of discussion. The process for election of a new chairman of the Basel Committee is private, as are the actual votes. You can’t apply for any of the jobs, nor can you learn how these jobs are allocated. I bet Sepp Blatter wishes he ran the Basel Committee.

Posted in: Basel by David /
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Today I want to look at another aspect of the RBS failure: regulatory change since the crisis, and how it measures up given what we know about RBS. As before, the FSA report into the failure of RBS will provide our material.

The causes of losses at RBS

What caused big losses at RBS? At the grossest possible level, 3 things, in order of significance:

1. Bad Loans
2. Buying ABN
3. Bad Trading Book assets

As FSA says:

“Between 2007 and 2010, RBS made net accounting losses of £30.7bn. This reflected £50.0bn of income net of tax and other expenses, offset by three main categories of loss.

• Losses of £32.5bn on loans and advances in RBS’s banking book, across a wide range of sectors and geographies…
• Goodwill write-offs of £30.5bn, of which £22.0bn resulted from the acquisition of ABN AMRO…
• £17.7bn on credit trading, arising from assets acquired both as a result of organic growth and as part of the ABN AMRO acquisition.”

(Page 120)

Just to ram the point home, here is a summary of RBS’s losses due to impairment charges in its banking book:

Regulatory change

FSA acknowledges that it has to do more about big strategic acquisitions like RBS buying ABN:

“Supervision has since modified its current approach to acquisitions to ensure that it is considerably more intrusive and challenging in its handling of major takeovers… The Review Team recommends that the FSA formalise its more intensive approach to major corporate transactions involving high impact regulated firms, by producing guidelines.” (Page 187)

Big changes have already happened in the capital regime for the trading book, and more are planned:

“A fundamental review of the market risk capital regime (including reliance on VaR measures) was required. This was recommended by the Turner Review, and is being undertaken by the Basel Committee. In the meantime, the Basel Committee has agreed a package of measures, including stressed VaR and enhancements to the capture of credit risk within the trading book, which is being implemented in the European Union.” (Page 93)

(If you are connoisseur of this kind of thing, you will recognise that ‘in the European Union’ as a dig at the FED.)

So, to summarise, FSA thinks that the pre-crisis regime for the causes of the second and third largest category of losses at RBS should be improved. What about the top cause? What about loans in the banking book? After all, both corporate property lending and corporate other (primarily ordinary corporate loans and loan committments) both caused bigger losses than all the trading book put together. Where’s the acknowledgement that the Basel II regime for the banking book was inadequate?

The closest we get is this:

“But it is now clear that the Basel II capital regime, introduced on the eve of the financial crisis, failed entirely to identify and address the issue of inadequate overall capital resources. As a result, the devotion of significant FSA resources to Basel II implementation failed to make any significant contribution to making RBS or any other major bank more robust in the face of the financial crisis.” (Page 270)

Now of course Basel III and the associated G-SIFI reforms have increased the total capital requirement for a bank like RBS from a 2% common equity tier 1 ratio to 9.5% or more. There are the liquidity reforms too: these represent potentially the most significant and most overdue changes in bank regulation in three decades. But still, I think a much more explicit acknowledgement that the Basel II regime for the banking book was inadequate is required. The trading book gets a lot of regulatory attention, yet it actually wasn’t the cause of the biggest issues at many banks including RBS. At least the FSA report gives us some data here. Doing something about the Basel II banking book capital regime, though, is another matter.

Update. Lest you think that RBS had an unusually poor loan book, here is how it compares to its peers:

The easy fix would be to increase the default correlations in the Basel II IRB formula, then recalibrate the common equity tier 1 ratio so that the changes are broadly neutral across the financial system. That would advantage large diversified banks less versus smaller, less systemic rivals, something that is surely systemically advantageous.

Posted in: Basel, Credit, Regulation by David /
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