Category / Basel

Fundamental review of the trading book news October 31, 2013 at 1:29 pm

The second consultative document on the fundamental review of the trading book is out: you can read it here. A few highlights:

  • “The Committee remains sceptical that existing internal models-based risk measurement methodologies used by banks can adequately capture the risks associated with securitised products. As a result, capital charges for securitisation positions in the trading book – including correlation trading activities – will be based on the revised standardised approach”. RIP CRM models.
  • “the Committee has decided that joint modelling of the discrete (default risk) and continuous (spread risk) components of credit risk is likely to involve particular practical challenges… As a result, the Committee has agreed that non-securitisation credit positions in the trading book will be subject to a separate Incremental Default Risk (IDR) charge”.
  • “the Committee has decided that it is not appropriate for CVA to be fully integrated into the market risk framework.
  • “the Committee has confirmed its intention to pursue two key reforms outlined in the first consultative paper: stressed calibration… [and] move from Value-at-Risk (VaR) to Expected Shortfall (ES)”.
  • “The Committee’s approach to address the risks posed by varying market liquidity consists of two elements: First, incorporating ‘liquidity horizons’ in the market risk metric… [Second] capital add-ons against the risk of jumps in liquidity premia.
  • “The Committee is taking a number of steps to strengthen the relationship between models-based and standardised approaches. First, it is establishing a closer link between capital charges resulting from the two approaches. Second, it will require mandatory calculation of the standardised approach by all banks. Third, it will require mandatory public disclosure of standardised capital charges by all banks on a desk-by-desk basis. Finally, the Committee is also considering the merits of introducing the standardised approach as a floor or surcharge to the models-based approach”.

It’s consultative, and you have until 31st January 2014 to get your comments in. Happy Christmas.

A few interesting links July 22, 2013 at 10:55 am

  • Izzy on the impact of the Basel leverage proposals on US repo, here.
  • Matt Levine on double standards in treasury losses, here.
  • Red Jahncke on size vs. complexity in TBTF breakups, here.
  • A timely reminder from the bond vigilantes on the impact of interest diversion triggers in RMBS, here.

Happy reading.

Measures, good and bad July 2, 2013 at 8:25 pm

The story of Thomas Hoenig’s `horrible’ assault on Deutsche got me thinking about multiple risk measures. Here’s the thing:

Long, long ago, we believed, or at least set up the regulatory framework as if we believed, that we could design a single measure of how safe a bank was. It was the RWA calculation.

More recently we have admitted that we can’t do that, and instead demand that banks meet a number of criteria: capital, leverage, LCR, and so on.

There are two problems. One is knowing when to stop. At some point, arguably already, the framework gets so complicated that no one knows what it does. There is an argument that less is more.

The second problem is that while having more ratios can prevent a false negative problem, as they backstop each other to some extent, they don’t prevent a false positive problem. The new leverage ratio, for instance, to put it charitably suffers from some design flaws which cause it to dramatically over-state risk*.

The key I think is that the backstops like the leverage ratio† need to be genuine backstops, and not new constraints for most firms. Then attention can be focussed on the one or two key measures which should work for most firms, and all large ones.

*This might partially explain Hoenig’s remarks.

†The leverage ratio as originally conceived was a backstop. Now you might argue – and Hoenig certainly would agree – that it should play a central role and be set much higher. That’s fine, but in that case you need something to backstop the cases where there aren’t many assets but they are all really risky.

Taking Sheila on holiday July 1, 2013 at 9:13 pm

I took Sheila Bair’s book away with me: it’s a decent (fast) read. Now, all autobiography is to some extent an exercise in self-justification, so one shouldn’t take anything on face value, but still she has some interesting things to say.

My favourite chapter is the early one on Basel 2. Bair quotes the capital savings that some large US banks would have achieved under the IRB (such as $14.6B for BofA – and that was pre-ML and Countrywide) focussing in particular on what I have always thought was the key issue with Basel 2, the overly-generous capital treatment of residential mortgages. She quotes an average reduction in capital here of 64%, a fairly shocking figure in the light of what happened to US mortgages in 2008. Bair did the right thing here, with the FDIC standing firm against, um, implementing what had been agreed to. As she says

To this day, not a single commercial bank or thrift [in the US] has ever used Basel 2 to set its capital requirements, and the Dodd-Frank financial reform law essentially killed Basel 2 as a means of reducing big bank capital.

That of course neatly brings us to the other major piece of influence of Bair’s on the capital framework, the Collins amendment. I’ve written before about what Collins does and Bair brings little new to that: what she does do, though, is give insight into how to get US legislation passed despite opposition from the FED, the big banks, and the OCC*. On those grounds alone, Chapter 19 is worth reading.

In short then, Bair’s book is worth a skim read. Her descriptions of Geithner are probably inaccurate, but they are amusing. She won’t be getting any invitations to Citi parties any time soon, I suspect, but I doubt that bothers her much, and her distrust of the safety of that institution in particular is interesting.

*Hint – having the amendment sponsored by one of the few Republicans who would vote with the Dems to get a key Act passed kinda helps.

High cost credit protection March 25, 2013 at 7:50 am

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.

Don’t cry for me, Credit Suisse March 1, 2013 at 6:52 pm

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.

PRA sense, EBA analysis February 27, 2013 at 5:42 pm

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.

Countercyclical theory and practice February 14, 2013 at 6:20 am

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.

Standards, gentlemen, standards February 4, 2013 at 6:29 am

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.

Not with a shout but with a lump January 13, 2013 at 2:44 am

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?

Homeopathic regulation January 7, 2013 at 2:47 pm

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.

Basel III, twice November 10, 2012 at 6:28 am

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?

G14 cull October 30, 2012 at 8:54 am

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.

On the other, the EU delays October 14, 2012 at 12:25 pm

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.

EU/US Basel spat October 2, 2012 at 9:17 am

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.)

EU Basel 3 miss September 11, 2012 at 6:54 am

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.

Getting fundamental September 4, 2012 at 6:01 am

My response to the fundamental review of the trading book is here.

Did someone just leave the door ajar? August 7, 2012 at 6:58 am

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…

Regulatory change – news from the department of big hints July 27, 2012 at 9:15 am

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.

Regulating the whale on alphaville June 15, 2012 at 12:11 pm

A slightly expanded version of this post on the JPMorgan losses, accounting, and CRM models is up on FT alphaville here.