Deus Ex Macchiato

Let’s imagine a conversation between banker Bob and a regulator Reg.

Reg: OK Bob. You screwed up big in 08. This time, I’m gonna make sure that your bank is safe. Damn safe.

Bob: Very well, Reg, I see your point. But what exactly do you mean by safe?

Reg: I mean that you have enough capital so that you can withstand losses. Any losses your stupidity might lead you to make.

Bob: Any losses?

Reg: Yep.

Bob: What is Godzilla climbs out of the Hudson, walks down 42nd street, and eats our headquarters. At the same time all our assets, including US treasuries, fall to zero, while all of instruments we are short go up. Do we need enough capital for that?

Reg: Well, no, obviously not, that’s stupid.

Bob: Of course – no one uses 42nd street if they can avoid it. 44th would be much faster.

Reg: You’re gonna have to have enough capital to withstand a real crisis.

Bob: What kind of crisis?

Reg: A bad one.

Bob: You will forgive me if I suggest that that is less than specific.

Reg: I know your game. If I say ‘once in a hundred years’, you buy billions of once in a thousand year risk. If I say ‘once in a thousand years’, you take a leveraged position in once in ten thousand year risk. I’m not gonna get caught out like that.

Bob: So I can’t take any risk?

Reg: Well obviously you can take some. Just not too much. And we want you to keep lending to the real economy, of course.

Bob: So ordinary banking – the kind of banking that has been responsible for banks failing for hundreds of years – is fine. But anything else is to be done in moderation. How much of that is too much pray tell?

Reg: Nothing that might make me have to rescue you.

Bob: This conversation is getting a little circular…

Posted in: Basel, Capital and Contingent Instruments, Regulation by David /
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Yves Smith at Naked Capitalism was kind enough to refer to some remarks I and the Streetwise Professor had made about Basel III. That got me thinking about what you can hope to achieve with any set of rules for internationally active banks.

First, some general points:

• The Basel II rules are far too complex. I think I finally lost it when I got to the section on early amortisation provisions for ABCP conduits. (Hang on, I said to myself, they know about conduits – a reg cap arb device – and instead of banning them, they write rules to distinguish slightly better from slightly worse ones? You what?) Therefore I’d set an arbitrary limit, 100 pages say, and require the rules to be no longer than this, ever.
• Basel is meant to be for internationally active banks. Not for hedge funds, not for investment managers, not for corporate finance advisers. The sooner the European Commission picks up on this and implements Basel not, as currently, for tens of thousands of firms, but instead for the twenty or thirty financial institutions with more than $100B of assets in the EU, the better. Everyone else is much less likely to be systemically important, and anyway have different businesses. Write rules that suit these different types of firms: don’t impose rules designed for BofA/Deutsche/HSBC on everyone in the name of the level playing field.
• Stop fighting the last war. The number of rules or proposed rules that address what happened to AIG is absurd, for instance. You might as well ban all capital markets participants whose names begin with A and have done with it.

Given this, what can we support in Basel III?

• Capital = net tangible equity. The redefinition of regulatory capital to be based on core tier 1, or something similar, makes sense.
• Gone Concern Capital. A mechanism which would allow banks to be recapitalised by converting sub debt into equity would also clearly enhance financial stability.
• Leverage. A backstop leverage ratio provides a useful mechanism to ensure that if risk based capital rules are wrong, the resulting distortions cannot become too large. Personally I would make it inversely proportional to asset size, so the bigger you get, the lower the leverage you are required to have.

These parts of Basel III, then, are reasonable. But beyond that, what can we do with capital, and what can’t we?

• Capital requirements can make the financial system safer. There is no doubt that better capitalised firms are safer, all things being equal, than less well capitalised ones.
• However, capital is not the only tool. Indeed, there is a sense in which it is the last tool, in that if you need it, it’s a bit late. Good risk management and plentiful liquidity are vital too – and it is typically a lack of these, rather than a lack of capital, that causes firms to fail.
• Broadly, risk sensitive capital requirements are bettter. This is so obvious that it hardly needs explaining. However,once you definite a particular notion of risk, there are issues. It may be feared for instance that firms might take risk in ways that are not captured by the notion chosen, or that they might concentrate on that notion at the expense of others. The answer here is not to keep on making capital requirements more complicated until the arbitrages become hard to find, but rather for supervisors to actually understand firms’ risk taking, and to fix any obvious flaws in risk management or in capital via pillar 2.
• Thus, I wouldn’t write thousands of rules. Instead I would say something like ‘Firms must have sufficient capital to cover the losses which might be expected in a one in a hundred year financial crisis. They must be able to demonstrate that this is so, and the full details of this demonstration must be published on a quarterly basis.’ This, in Krugman’s terminology, would be a greek rather than a roman rule.
• All of this would mean that there are distortions. Bank A would have more capital for a given activity than Bank B. But that happens already – in part due to the use of internal models. But at least rather than getting false comfort from hundreds of pages of rules, supervisors, investors, counterparties and analysts would know that they had to analyse bank’s risk disclosures and capital calculations carefully.

Posted in: Basel, Capital and Contingent Instruments, Rules by David /
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(My apologies for the dearth of posts recently: I acquired a horrible cold and it took me some days to kick it.)

A long time ago I became interested in economics when someone – to my shame I can’t even remember who – pointed out that it wasn’t just dull money stuff, but rather that it was the study of incentive structures. That still strikes me as true today: a good piece of economics explains how and why we react to changes in incentives.

It is therefore somewhat surprising to find that some commenters on bank regulation – and even some regulators – can be so bad at understanding incentive structures. If you make an activity really difficult or expensive for banks to do, but it is profitable, then non-banks will figure out a way to do it (usually in a badly capitalised, unregulated vehicle). Moreover, if you make one way of taking a risk really difficult and expensive but another way of taking the same risk much cheaper, then banks will take it in the second way not the first. That is why I have always advocated regulators having a specialist regulatory arbitrage group to spot these features and plug them. But of course the problem with this is that the existence of the group would be tacit admission that the rules are not fair between different risks and not risk sensitive either. That would never do.

Basel III, as one might expect for something written in an awful hurry and without the luxury of much impact analysis, will make this situation worse. It adopts the same approach to regulatory capital as I apply to wrapping parcels: keep on adding things piecemeal until it looks bulky enough to survive. I can go through half a roll of tape for a big parcel, and the result is always ugly. Sadly the consequences of adding extra lumps of capital here and there are equally ugly but less likely to result in safety: they could well result in risk leaving the banking system, and/or banks optimising the channels of their risk taking. The fact that these consequences are not obvious to the Basel Committee is deeply dispiriting. It isn’t quite too late to fix these problems, but with the full Accord due in October, the clock is ticking…

Posted in: Basel, Regulation by David /
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From the Committee, edited down for brevity:

The Committee retained most of the definition of capital proposals set out in the December 2009 consultative package. However, it concluded that certain deductions could have potentially adverse consequences and may not appropriately take into account evidence of realisable valuations during periods of extreme stress. Therefore, the following amendments to the December 2009 proposal have been agreed.

Definition of capital

The Committee will allow some prudent recognition of the minority interest supporting the risks of a subsidiary that is a bank. The excess capital above the minimum of a subsidiary that is a bank will be deducted in proportion to the minority interest share.

The December 2009 reform package required that unconsolidated investments in financial institutions be deducted when the holdings exceed certain thresholds. These thresholds continue to apply. The December paper also stated that gross long positions may be deducted net of short positions only if the short positions involve no counterparty risk. The Committee agreed to eliminate this counterparty credit restriction on hedging of financial institution investments and to include an underwriting exemption.

Instead of a full deduction, the following items may each receive limited recognition when calculating the common equity component of Tier 1, with recognition capped at 10% of the bank’s common equity component:

• Significant investments in the common shares of unconsolidated financial institutions. “Significant” means more than 10% of the issued share capital;

• Mortgage servicing rights (MSRs); and
• Deferred tax assets (DTAs) that arise from timing differences.

A bank must deduct the amount by which the aggregate of the three items above exceeds 15% of its common equity component of Tier 1.

Counterparty credit risk

The Committee is making the following modification to the treatment of counterparty credit risk, including the bond equivalent approach to calculating the credit valuation adjustment (CVA):

• Modify the bond equivalent approach to address hedging, risk capture, effective maturity and double counting;

• To address the excessive calibration of the CVA, eliminate the 5x multiplier that was proposed in December 2009;
• Keep the asset value correlation adjustment at 25% to reflect the inherent higher risk of exposures to other financial entities and to help address the interconnectedness issue, but raise the threshold from $25 billion to $100 billion; and
• Banks’ mark-to-market and collateral exposures to a central counterparty (CCP) should be subject to a modest risk weight, for example in the 1-3% range, so that banks remain cognisant that CCP exposures are not risk free.

Leverage Ratio
The Committee agreed on the following design and calibration for the leverage ratio, which would serve as the basis for testing during the parallel run period:

• For off-balance-sheet (OBS) items, use uniform credit conversion factors (CCFs), with a 10% CCF for unconditionally cancellable OBS commitments (subject to further review).

• For all derivatives (including credit derivatives), apply Basel II netting plus a simple measure of potential future exposure based on the standardised factors of the current exposure method.
• The leverage ratio will be calculated as an average over the quarter.

When it comes to the calibration, the Committee is proposing to test a minimum Tier 1 leverage ratio of 3% during the parallel run period.

The parallel run period commences 1 January 2013 and runs until 1 January 2017. During this period, the leverage ratio and its components will be tracked, including its behaviour relative to the risk based requirement. Bank level disclosure of the leverage ratio and its components will start 1 January 2015.

Procyclicality, systemically important financial institutions, and the net stable funding ratio have all been kicked into the long grass, with further proposals at the end of the year (i.e. past the G20 Basel 3 deadline of November).

The Liquidity coverage ratio stays, but with some recalibration:

• Retail and SME deposits: Lower the run-off rate floors to 5% (stable) and 10% (less stable), respectively (from 7.5% and 15%). These numbers are floors and jurisdictions are expected to develop additional buckets with higher run-off rates as necessary.

• Operational activities with financial institution counterparties: Introduce a 25% outflow bucket for custody and clearing and settlement activities, as well as selected cash management activities.
• Deposits from domestic sovereigns, central banks, and public sector entities (PSEs):
  • For unsecured funding, treat all (both domestic and foreign) sovereigns, central banks and PSEs as corporates (ie with a 75% roll-off rate), rather than as financial institutions with a 100% roll-off rate.

  • For secured funding backed by assets that would not be included in the stock of liquid assets, assume a 25% roll-off of funding.
• Undrawn commitments: Lower retail and SME credit lines from 10% to 5%. Treat sovereigns, central banks, and PSEs similar to non-financial corporates, with a 10% run-off for credit lines and a 100% run-off for liquidity lines.
• Inflows: Rather than leave it to bank discretion to determine the percentage of “planned” net inflows, establish a concrete harmonised treatment in the standard that reflects supervisory assumptions.
• Definition of liquid assets: All assets in the liquidity pool must be managed as part of that pool and are subject to operational requirements. The December 2009 proposal outlined that the assets must be available for the treasurer of the bank, unencumbered, and freely available to group entities. The Committee will finalise these operational requirements by the end of this year.

  As part of the narrow definition of liquid assets, allow the inclusion of domestic sovereign debt for non-0% risk weighted sovereigns, issued in foreign currency, to the extent that this currency matches the currency needs of the bank’s operations in that jurisdiction.

• Introduce a “Level 2” of liquid assets with a cap that allows up to 40% of the stock to be made up of these assets.
  • Include (with a 15% haircut) government and PSE assets qualifying for the 20% risk weighting under Basel II’s standardised approach for credit risk, as well as high quality non-financial corporate and covered bonds not issued by the bank itself (eg rated AA- and above), also with a 15% haircut.

  • Utilise both ratings and additional criteria as outlined in the December proposal (bid-ask spreads, price volatility, etc) to determine eligibility.
• Develop standards for review at the September 2010 BCBS meeting for jurisdictions which do not have sufficient Level 1 assets to meet the standard.

Posted in: Basel, Regulation by David /
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Underground, overground, Baseling free
The people of the BIS thirty are we
Making good use of the things that we find
Things that the everyday banks leave behind

OK, OK, that was a cheap shot, but I did like the Wombles when I was a kid, and the Basel Committee is meeting today to work on Basel 3. (If you want to be pedantic, it’s 27 countries not 30, but the EU has a seat too, as does the secretariat, and that is close enough for government work.) So, in the spirit of good natured advice to the committee, which I fully expect to be utterly ignored, here’s what I think they should do today.

The definition of capital. Clearly, something needs to be done. Equally clearly, you cannot do it quickly, because asking the banking system to raise hundreds of billions of new equity in a hurry is a recipe for instability and dramatic falls in credit supply. So, yes, set a 4% core tier 1 ratio as the target, but do it over ten years, and amortise in the effect every year. Declare all tier 1 and upper tier 2 instruments as de facto core tier 1 for now, then let that bleed out over time. Require a total capital ratio of 10% also in ten years, again amortising from now to then. Allow contingent capital as part of tier 2. Remove the asymmetric treatment of deductions in subsidiaries, but make DTAs tier 2.

Liquidity. This for me is the most important part of the proposal to get right. Both the net stable funding ratio and the liquidity coverage ratio are good ideas, but the definitions are flawed. On the NSFR, a lot of work with the quantitative impact study results will be needed to figure out what financial institutions (and I don’t just mean banks – remember this is being implemented in the EU for all investment firms) can get to without severe stress in the liquidity markets. Consider an explicit capital charge for interest rate risk in the banking book, too. For the LCR, a liquidity stress test is a good idea, but it should probably be a pillar 2 issue with extensive pillar 3 disclosure.

Leverage. Define an on balance sheet leverage ratio, but base it on the statutory accounts assets vs. shareholder’s funds, (relying on accounting standards convergence to level the playing field). Give banks five years to meet the target, and make the ratio large so it acts as a last ditch backstop rather than an everyday constraint. Thirty or thirty five to one might do it.

Counterparty risk. The previous proposals were far too severe. One might suspect that they could have been politically motivated, that is designed not to cover risk, but rather to incentivise a move to CCPs. It really is back to the drawing board time here I would suggest.

Anticyclical measures. Do further study and work with the accounting standards setters to develop forward looking provisioning methods. Then, once you have a good definition of an expected loss provision, in the capital rules add an explicit countercyclical provision based on historical max EL vs. current EL.

Other things that should be done (but won’t be). Fix the low correlations for retail mortgages in the Basel 2 IRB formula. Change the requirement for securitisation retentions from 5% flat to be a function of the weighted average coupon of the underlying assets. Remove the ill-judged trading book VAR plus stressed VAR plus IRC charge, and instead implement max(VAR, stressed VAR) plus max(IRC, stressed IRC). This would be countercyclical and a reasonable holding position until the committee has time to get back to the trading book issues.

The Committee then needs to promise to do a full impact study of the new proposals and rewrite where necessary in 2011.

That was cathartic to write, in the way that fantasies sometimes are.

Update. The press release from the meeting is here: it says rather little, apart from setting out a new counter-cyclical buffer proposal. That’s here: I will have a look at it shortly.

Update. I can’t resist quoting this summary of Basel 3 from FT Alphaville:

In short: a complex rule cut to the crazy-quilt cloth of financial globalisation, to be implemented roughly once every geological epoch and with uncertain ultimate impact on the real economy.

Harsh, but not clearly unfair.

Posted in: Basel by David /
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It is definitely make the banks better capitalised but not yet. From the FT today:

…the G20 has watered down the previous target of achieving the new capital standards by the end of 2012. That date is now downgraded to an “aim”.

But to keep individual countries with weak banks happy, the phase-in of the new global rules “will reflect different starting points and circumstances with initial variance around the new standards narrowing over time as countries converge”, the communiqué added.

The Basel consensus will probably hold, but only at the expense of a long transition period and weaker standards.

Posted in: Basel by David /
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The latest Bank of England financial stability review contains the following interesting passage:

Finalisation of the Basel III package will take place this year. This should provide banks and other market participants with a clearer view on future regulatory requirements, thereby reducing uncertainty. But it is important that policymakers also provide clarity over the implementation timetable for the new requirements.

Although higher levels of capital will ultimately be needed, it would not be appropriate for banks to be increasing their capital buffers immediately if this were at the expense of a reduction in lending to the real economy. Work is under way internationally to gauge these transitional costs. The transition to new regulatory standards does not need to be rushed and should, in principle, be contingent on the economic environment.

Combine this entirely sensible thinking with the increasingly-discussed risk of a double dip recession, as in this quote from today’s Guardian –

Signs of deep rifts at the G8 and G20 summits in Toronto over how quickly governments should cut deficits added to financial market jitters today, with the Americans warning of the dangers of a double dip recession if all countries started to rein back spending at once.

What that leaves you with is the financial analogue of St. Augustin’s famous quote: make the banks better capitalised but not yet. The Basel committee meeting to finalise the third accord is certainly going to be interesting.

Update. Even Robert Preston has noticed the issue. As he says, the fear is that if we insist that banks lend less and less riskily relative to their capital at this particular juncture, they’ll respond by turning off the credit tap more-or-less completely – and we’ll be tipped back into recession.

Posted in: Basel by David /
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Bloomberg reports:

HSBC Holdings Plc’s $3.4 billion issue of undated 8 percent notes marks the first sale of debt securities designed to qualify as capital under current and proposed bank regulations.

The bonds count as so-called Tier 1 capital under current rules by permitting HSBC to defer coupons in some circumstances and benefit the bank because it pays interest from pretax earnings, according to the deal’s prospectus. To meet new terms proposed by regulators, HSBC can convert the notes into preference shares that pay dividends from after-tax earnings…

The Basel Committee on Banking Supervision proposed in December phasing out so-called innovative hybrid securities such HSBC’s because they failed to absorb losses during the financial crisis. When the rules change, set for the end of 2012, innovative securities issued after the proposal date won’t qualify as Tier 1 capital.

Close, but no cigar. It is not clear when the grandfathering date will be: it certainly might be earlier than the end of 2012. So this is a ballsy play from HSBC. They are essentially gambling that these notes will count as capital: and they have a par call in Dec 2015 in case they don’t.

Investor demand for this issue was immense: initial guidance was 300 million, so the deal was upsized over ten times. This shows that the lack of recent bank issuance – caused by uncertainty over what will count as capital in Basel 3 – has left investors panting for good quality names. We will surely see other banks issuing similar deals in the coming months. Once it is clear what will count as capital, everyone will be coming to market: the smart players will get ahead of that wave.

Posted in: Basel, Capital and Contingent Instruments by David /
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FT Lex (behind an increasingly annoying firewall) says:

…a bank should not have to hold as much capital against US government debt as for complex structured loans. Basel … rules therefore attribute different capital ratings according to risk. At the top of the pile, government bonds rated AA and above are assigned a zero risk weighting.

They then suggest that this is a problem, and that banks should not be able to use infinite regulatory capital leverage on e.g. buying Spanish government bonds.

I agree, and I think that the lowest risk weight should be 3 or 4% rather than 0%. (That is, after all 25 or 33x leverage.) But note that the FT’s point is not true in the capital rules used by most large and many medium sized banks, the IRB: it only applies to the standardized approach. In the IRB, the minimum PD is 0.03% rather than 0%. That is not enough, as we suggested earlier, but it is a good start. The proposed Basel III balance sheet leverage constraint might help here too, if it is well-designed (which the current proposals aren’t). In fact, it occurs to me that you can kill two birds with one stone: there would be no need for the leverage requirements if you removed 0% risk weights in the standardised approach and set the minimum PD high enough (0.07%? 0.1%??) in the IRB.

Update. I got one of the details wrong above. If the risk weight is 4%, then the capital charges is 4% of 8% of notional, or 0.32%. That’s 1 / 0.32% or 312x leverage. Ouch. Maybe a 10% minimum risk weight is more like it.

Posted in: Basel, Credit by David /
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Bloomberg points out something that we should be quite troubled by:

In 2,615 pages of financial reform legislation introduced in the U.S. Congress, there are no rules to ensure that banks keep enough cash-like assets when credit disappears.

Guidelines on liquidity risk management, which were published March 17 by the Federal Reserve, the Treasury Department and the Federal Deposit Insurance Corp., also avoided spelling out how much banks need to hold, and in what form, to make sure they don’t collapse if short-term lending dries up…

“They’re assessing the processes and monitoring of liquidity but not addressing the quantities of liquidity that banks need to hold.”

The issue here is regulatory creep. When times are good, banks will reduce their liquidity buffers, and this will seem reason to regulators. They will hold back egregious reductions, but they might be unable to stop a slow trend where banks become less liquid.

The Basel committee had proposed something a lot tougher here: a 100% net stable funding ratio, meaning that all of a bank’s anticipated funding needs over a one year horizon would have to be met by deposits and long term financing. That, of course, would dramatically reduce the profitability of many banks since they make a lot of their money from punting the yield curve – funding short and lending long. The view of the experts polled by Bloomberg is that the Basel proposal will be watered down substantially.

This is shameful. Liquidity risk is a major vector, perhaps the most important vector, of bank failure. Without fixed liquidity rules, banks and non-bank financials will fail more easily: rules like this would have meant that Bear Stears and Lehman could not have got into trouble the way they did. Add in a firm, low leverage ratio, like 15%, and we would have gone a long way towards making the financial system more robust. The failure to address liquidity risk with a fixed net stable funding requirement is a massive missed opportunity and we should decry it.

Posted in: Basel, Liquidity and liquidity risk by David /
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FT Alphaville picks up a warning from Credit Suisse Research on one of the more obscure aspects of Basel III (2.5?), credit valuation adjustments.

There are several things going on here. First the idea is that you should mark credit on bilateral contracts so that if we do a swap, I discount net cashflows from you to me at your credit spread, and vice versa (absent collateral and assuming that netting works). The regulators then say, OK if you are doing that, then you will have losses on in-the-money uncollateralised OTCs as your counterparty’s spread widens. Those losses were substantial in the Crunch: apparently 2/3rds of total losses due to counterparty risk arose this way, rather than through default. Therefore, the argument goes, there should be capital against unexpected losses here to a suitable degree of confidence.

The problem that CS identify is that the capital amounts required under the calculation the BCBS propose could be large. For some banks, really quite large. At the moment we are still in the comment stage of the Basel proposals, so there is no need to panic. But if CS are right about the numbers, it might be time for the industry to get pen and ink out. The deadline for comments is the 16th April.

Posted in: Basel, Credit, Derivatives, Hedging and Convexity by David /
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I mean that as in the ‘nature red in tooth and claw sense’. One of the many reasons that Basel 2, 3, pick a number, is bollocks, is that it permits little diversity, at least if taken seriously. (Some countries don’t take it seriously, of course.) We’d be better off letting countries innovate, and then seeing what works.

Joseph Stiglitz agrees. Writing in the FT, he says

…each country is responsible for ensuring the safety and stability of its financial system and economy, and for protecting its citizens. It is dawning on leaders – in some cases egged on by rightly impatient voters – that we cannot wait for co-ordination. It is far better to have strong action now and then harmonise the regulatory structures later. It may be “second best” – but far better than the third-best alternative of delayed and ineffective regulation.

We’ll see. The forces of Basel bollockery are strong, and the siren cry of the level playing field is still effective. But I honestly think the financial system would be stronger if each country went its own way. At least then global systemic crises would be less likely.

Posted in: Basel, Regulation, Rules by David /
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From Laurie Goodman at Amherst Securities via the Big Picture:

Freddie will likely lose around $178 billion of its $1.86 trillion credit guarantee book, and Fannie will likely lose $270 billion of its $2.81 trillion book. Combine the credit guarantee books of the two firms, and you reach a $4.67 trillion book, with estimated losses at just under 10%, or $448 billion.

My, that is a big number. And of course it suggests that the right capital haircut for residential mortgages is not 4% as per Basel, but rather 8-10%.

Posted in: Basel, Federal Agency, Mortgages by David /
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This came up in FT alphaville a little while ago, and I should get back to it. It is a somewhat complicated story, so let’s take it slowly.

Firstly, the new Basel proposals:

No adjustment should be applied to remove from the Common Equity component of Tier 1 unrealised gains or losses recognised on the balance sheet.

In other words, Basel says that in future, the regulation should go like the accounting. So how does the accounting go?

Going forward, the IASB suggest that there will be two measurement-categories for financial instruments

• fair value; or
• amortised cost.

And in particular available for sale accounting – which is pretty commonplace at the moment – will disappear.

Thus firms have to elect either fair value or accrual for an asset, and if they select fair value, gains and losses will immediately feed through into regulatory capital. We have commented on the vicious circle this introduces earlier – small losses erode capital which increases leverage which forces asset sales turning unrealised losses into realised ones.

Banks will not want that. So what will happen? JPMorgan (via FT alphaville) suggest:

By avoiding adjustments for unrealised gains or losses, the regulators are putting more pressure on the accounting model. In other words, if the accounting treatment assigning a valuation measure (i.e. amortised cost or fair value) is essentially automatically determining the regulatory treatment, this may lead banks to be more motivated to exploit perceived advantages of using accounting categorisations that are most favourable for regulatory purposes. This may encourage banks to maximise the amount of financial instruments which are classified in the amortised cost category, so there are no mark-to-market gains or losses on balance sheet and regulatory capital is more stable.

That seems entirely likely. Thus the combination of a seeming rationalisation – making the regulation follow the accounting – and doing away with AFS means that we will get less transparency on the value of bank assets and less volatile, i.e. accurate regulatory capital estimates. Bravo.

Posted in: Accounting, Basel by David /
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The market’s reaction to the latest Basel committee document was swift and severe: bank share prices fell significantly. However, a close reading of the proposals suggests that those falls might be overdone. Here’s the good news/bad news skinny: (where I’ve used ‘good’ to mean ‘good for the banks’ – the skeptical might well take that to mean ‘bad for financial stability’)

Bad news: the predominant form of capital will eventually be common equity and retained earnings. Funkier capital instruments, such as innovative tier 1 instruments (a form of callable step up bond) will be phased out.

Good news: not yet. Moreover, existing instruments will likely be grandfatherered. Furthermore, the calibration of the new capital levels is going to be based on an impact study, making it likely that banks that are average or better will be fine. There is no firm indication, in this document at least, that most banks will have to raise more capital.

Bad news: unrealised gains on available for sale instruments may not be acceptable capital.

Good news: that was only important in a few places, such as Japan, anyway.

Bad news: goodwill and deferred tax assets are a deduction from capital.

Good news: the market thought that they were anyway.

Bad news: significantly higher capital requirements for counterparty credit risk.

Good news: this provides a great lever for firms to use to persuade their counterparties to sign tighter margin/collateral agreements. Renegotiation of credit support annexes could remove much of the extra capital required.

Bad news: an overall constraint on balance sheet leverage.

Good news: again, set using an impact study, and hence likely only to impact outlier institutions.

All in all, this is much better than the industries’ worst fears. Whether you think that is good news or bad news depends on your perspective.

Posted in: Basel, Capital and Contingent Instruments, Credit, Regulation by David /
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…now get more capital.

That seems to be the message anyway. The press release is here, with links to two consultative papers. Full analysis follows next week, but on first glance there does not seem to be anything particularly unexpected in the document: leverage ratios, countercyclical capital requirements, high standards of liquidity risk management, and high quality capital are all there.

Posted in: Basel, Regulation by David /
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My apologies for the chart overload of late: this is the last one for a while, I promise. But it is a good one. Taken from the Turner Review (discussed previously here), it shows the very long term trend in capital adequacy for UK banks calculated by various authorities. The hint from FSA is clear: capital used to be higher, and it might well have to be higher again…

Update. An excellent commentary, from Piergiorgio Alessandri and Andrew G Haldane, illustrates the point very well:

[The ratio of] UK banks’ balance to GDP … is flat for almost a century, at around 50%… But from the early 1970s, this pattern changed dramatically. By the start of this century, bank balance sheets were more than five times annual UK GDP. In the space of a generation, the insurable interests of the state had risen tenfold.

By itself, this expansion of balance sheets need not imply that the state was bearing greater implicit risk. For example, banks could have self-insured by holding larger buffers of capital and liquidity. In practice, the opposite happened…

Since the start of the 20th century, capital ratios have fallen by a factor of around five in the US and UK. Liquidity ratios have fallen by roughly the same amount in half that time. Taken together, these balance sheet trends indicate a pronounced rise in banking system risk and hence in potential demand for state insurance. They have also affected the returns required by bank shareholders…

Between 1920 and 1970, the return on UK banks’ equity averaged below 10% per annum, with low volatility of around 2% per year. This was roughly in line with risks and returns in the non-financial economy… The 1970s signalled a sea-change. Since then returns on UK banks’ equity have averaged over 20%. Immediately prior to the crisis, returns were close to 30%. The natural bedfellow to higher return is higher risk. And so it was, with the volatility of UK banks’ returns having trebled over the past forty years.

This regime shift upwards in the risk and return profile of UK banks can be explained by the fall in their capital ratios. Higher leverage boosts required returns on equity because it simultaneously makes the banking system’s balance sheet more fragile.

Posted in: Basel, Capital and Contingent Instruments by David /
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I have blogged before about most of the proposals in this document from the commission, including the incremental risk charge in the trading book and the revised treatment of resecuritisation (CDO squared) positions, but I have not said much about stressed VAR. So without further ado:

Each institution must meet, on a daily basis, a capital requirement of:

1. The higher of (1) its previous day’s value-at-risk number; and (2) an average of the daily value-at-risk measures on each of the preceding sixty business days, multiplied by the multiplication factor;
   plus

2. The higher of (1) its latest available stressed-value-at-risk number; and (2) an average of the stressed value-at-risk numbers over the preceding sixty business days, multiplied the multiplication factor (m);
   plus

3. The sum of its weighted positions (regardless of whether they are long or short) resulting from the application of point 16a of Annex I (the treatment of securitisation positions);
   plus

4. The higher of the institution’s most recent and the institution’s 12 weeks average measure of incremental default and migration risk according to point 5a (the IRC charges).

(Note those pluses.)

The description of stressed VAR is fairly vague:

Each institution must calculate a ‘stressed value-at-risk’ based on the 10-day, 99th percentile, one-tailed confidence interval value-at-risk measure of the current portfolio, with value-at-risk model inputs calibrated to historical data from a period of significant financial stress relevant to the firm’s portfolio. This stressed value-at-risk should be calculated at least weekly.

Posted in: Basel, Capital and Contingent Instruments, Regulation by David /
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Continuing a long line of dry posts about regulatory capital, a summary of some of the most recently proposed changes to the CRD:

• … credit institutions should… build up through-the-cycle expected loss provisions for credit risks during good times … and use these provisions during a downturn to cover (some) of the incurred losses. Through-the-cycle expected loss provisioning is essentially a countercyclical measure for timely capturing expected losses due to inherent credit risks that have not yet materialised as ‘incurred’ losses. The through the cycle provisioning should be applied to items on the balance sheet (such as loans) and possibly to off-balance sheet items (such as guarantees). It is different from countercyclical regulatory capital approaches that basically provide a capital buffer for unexpected losses.

• … the Commission is considering imposing additional and specific capital requirements for loans for residential property that are denominated in a currency other than that of the income of the borrower.
  Those additional requirements would apply above a specified loan to value ratio: up to a low and conservative loan to value ratio…

• There is also some measure of harmonisation of various areas of national discretion within the rules.

The illustration is a roadmap of CRD changes: subsequent posts will address some of the other areas.

Posted in: Basel, Capital and Contingent Instruments, Regulation by David /
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The Quantitative Impact Study from the BCBS is here. Broad brush conclusions:

• Trading book capital roughly doubles, overall capital up c. 11%

• Three components are of very roughly the same size: the incremental capital charge; stressed VAR; and the new specific risk charges.
• The stressed VAR is on average 2.6x the unstressed VAR.

More analysis will follow once I have had a chance to digest the details.

Posted in: Basel, Capital and Contingent Instruments, Regulation by David /
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Glorious, glorious, glorious is the day: yet more Basel. Here’s a key passage from BCBS158:

Factors that are deemed relevant for pricing should be included as risk factors in the value-at-risk model.

If you took the committee at its word, here, no one would have a VAR model. Just consider an equity derivatives book on underlyings in the Eurostoxx. There are 50 underlyings, 50 dividend yields (more if you consider the term structure of dividend yields), at least 20 interest rates in Euros, and as many implied volatilities as you have (strike, maturity) pairs for your options. A decent sized book will have many hundreds, perhaps many thousands, of risk factors. No one has a VAR model with all of those factors in it. So, what is a bank to do? Let’s turn back to the committee:

Where a risk factor is incorporated in a pricing model but not in the value-at-risk model, the bank must justify this omission to the satisfaction of its supervisor.

Ah lovely. So if you have a tolerant supervisor, perhaps because you are in a small country, or because you are a national champion bank, all is well. If not, you will have some hoops to jump. This provision in short is a charter for regulatory arbitrage. The next part is even worse:

In addition, the value-at-risk model must capture nonlinearities for options and other relevant products (e.g. mortgage-backed securities, tranched exposures or n-th-to-default credit derivatives), as well as correlation risk and basis risk (e.g. between credit default swaps and bonds). Moreover, the supervisor has to be satisfied that proxies are used which show a good track record for the actual position held (i.e. an equity index for a position in an individual stock).

If this doesn’t make players with big trading books redomicile to somewhere small, low tax and friendly, I don’t know what will.

Posted in: Basel, Regulation by David /
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The review of the changes to Basel 2 now moves to the credit risk rules. There isn’t much that is new here either: some tweaking of the credit conversion factors for liqudity facilities, and a new, seemingly penal treatment of CDO squared positions (which the committee in keeping with its mission to call everything by a different name to everyone else, call resecuritisations). Here are the risk weights:

Two things spring to mind at once. The classifying criteria is rating. That’s right – the ratings agencies, who did such a sterling job at rating ABS that they are facing multiple lawsuits and much approbrium, are still at the heart of regulatory capital. And given that, 20% is hardly penal for a AAA CDO squared tranche. Roll on re REMIC.

Posted in: Basel by David /
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First the simple part. The new revisions to the Basel capital accord include Incremental Risk in the Trading Book. I have already commented on these proposals before, and there is nothing really new in the final version. In particular, there is still no clarity over what specific risk might be for, exactly, if you have incremental risk charges as well. My inference is that the IRC proposals are for those who are using a VAR modelling approach, and that the ordinary specific risk haircuts apply to everyone else. But (so far as I can see) the modellers have to calculate both a specific risk VAR and the IRC.

[My interpretation of the scope of the IRC is based on the following text from BCBS159: 'the IRC encompasses all positions subject to a capital charge for specific interest rate risk according to the internal models approach to specific market risk but not subject to the treatment outlined in paragraphs 712(iii) to 712(vii) of the Basel II Framework', 712(iii) to (vii) being the standard rules approaches for specific risk. Caveat lector.]

Posted in: Basel by David /
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I flatter myself that I was one of the first bloggers (although far from the first academic) to comment on the need for anti-cyclical capital rules. Three years later, this is becoming accepted wisdom. People still seem to think that identifying the cycle is difficult. I’m sure it is not, and I identified a number of indicators that could be used to set capital levels in my book. Now the BIS annual report has reviewed several possible indicators: credit spreads, changes in real credit provision, and a composite indicator that combines the credit/GDP ratio and real asset prices. And, rather unsurprisingly, they all work to a reasonable degree.

Posted in: Basel, Capital and Contingent Instruments, Regulation by David /
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As part of a series on the new Basel Committee Trading Book proposals, notice first that the text contains quite a sophisticated notion of time horizon:

A bank’s IRC model must measure losses due to default and migration at the 99.9% confidence interval over a capital horizon of one year, taking into account the liquidity horizons applicable to individual trading positions or sets of positions. Losses caused by broader market-wide events affecting multiple issues/ issuers are encompassed by this definition.

This… implies that a bank rebalances, or rolls over, its trading positions over the one-year capital horizon in a manner that maintains the initial risk level, as indicated by a metric such as VaR or the profile of exposure by credit rating and concentration. This means incorporating the effect of replacing positions whose credit characteristics have improved or deteriorated over the liquidity horizon with positions that have risk characteristics equivalent to those that the original position had at the start of the liquidity horizon. The frequency of the assumed rebalancing must be governed by the liquidity horizon for a given position.

Posted in: Basel by David /
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They say… CDOs of ABS (so-called “resecuritisations”) are more highly correlated with systematic risk than are traditional securitisations. Resecuritisations, therefore, warrant a higher capital charge. Fine so far. But then look what they do:

(The new capital charges are in the grey hatched columns.) So the capital charge for a senior charge of a AAA-rated CDO-squared will be 1.6% of notional (20% x 8%). Anyone who thinks this is adequate was clearly taught in the Jimmy Cayne school of Structured Finance.

Update. I’ll try to post more on the Basel 2 revisions (and in particular the trading book changes) in a few days. Meanwhile here is some good sense from Adair Turner, via the FT:

Lord Turner told a hearing of the Treasury select committee that tougher measures would include requiring banks to hold up to three times as much capital against their trading assets.

Posted in: Basel, Regulation by David /
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Mark to market is great. It gives the users of financial statements the best information available about the value of a company. But, as we have seen over the last year or so, it also has the drawback – at least when applied to banks and such like – of encouraging procyclicality. On the way up, mark to market gains, once audited, form retained earnings, and so contribute to capital. This capital can then support more risk. On the way down, losses reduce capital and so inhibit risk taking just when it is vital for the economy that financial institutions to step up to the plate.

So…. let’s split the link between unrealised gains and retained earnings. Specifically, I propose splitting the retained earnings component of tier 1 into two pieces. The first, retained realised earnings, would be as before. The second, retained unrealised earnings, would be the sole component of a new class of capital, tier 4. (Tier 1 is equity and highly equity like capital; tier 2 is reserves and certain types of long term sub debt; tier 3 is short term sub debt.)

Unrealised gains and losses would change tier 4. There would be constraints on the total amount of capital that could come from tier 4, just as there is today on the total that can come from tier 2. Exactly what would work needs some research, but my guess is that, say, having a rule like tier 1 must be 8 times bigger than tier 4 would work. On the way up, this would restrict the benefit available from unrealised gains. That buffer would then be available to absorb losses on the way down without restricting risk taking.

Posted in: Basel, Capital and Contingent Instruments, Regulation by David /
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I have sniped, perhaps too much, at Basel 2. So it only seems reasonable to outline some alternative proposals, particularly as Lord Turner is apparently open to significant change. Here goes.

Scope. Capital charges should apply to assets, derivatives, and to asset/liability mismatch. In particular funding mismatch and the heavy use of confidence sensitive short term funding like repo should generate a capital charge.

Risk types. There should be capital for market risk, credit risk, counterparty risk and funding liquidity risk. If there is a need for an operational risk charge, it should be a simple expenditure-based requirement.

Models. Given the spectacularly bad performance of risk models, these should be banned for regulatory capital purposes. In particular no diversification benefit should be given. Total capital requirements should be derived by adding up the capital requirements for each risk type.

Asset Liquidity. This should be explicitly included in capital requirements, with market risk capitals being scaled by root t for assets whose liquidation horizon is longer than typical. (Implicitly the current horizon is ten days, so this is a good start.)

Haircuts. These should reflect a prudent move across the cycle. For equity indices, for instance, a reasonable capital charge would be the biggest loss resulting from an 8% move up or down in the index. [For any reg. junkies out there, what I am envisioning here is rather similar to the CAD 1 approach used before the 1996 market risk amendment.]

Anti-cyclicality. There should be a capital buffer over and above the calculated minimum, varying from 25% or more at the good points in the cycle to essentially nothing in a crisis. The availability and cost of leverage, volatility measures, and market returns should be used to determine where we are in the cycle.

Credit risk in the banking book. The revised standardised approach in Basel 2 is not too bad for corporate risk, but it is far too generous for retail and mortgage risk. It’s badly designed for securitisations. Revisions will be needed to these capital charges.

Credit instruments in the trading book. These charges need to be completely redesigned.

Posted in: Basel, Regulation by David /
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The first from Clusterstock:

Many of our financial institutions are insolvent. They aren’t healthy victims of bank runs. They are ailing institutions barely kept alive by frantic rounds of capital raising. The lessons of the Great Depression simply don’t apply here.

In fact, we’re probably making things worse. Allowing insolvent institutions to fail and requiring worthless and worth less assets to be fully written down would provide transparency to the market. Instead, we’re dedicated to the post-Lehman proposition of “Never Again.” The various programs of our government continue to obscure asset pricing and conceal insolvency. This means that you can’t trust the market to tell you which firms are failing.

Twisting the arms of bankers to lend to institutions that may be insolvent is a recipe for deepening the crisis. We’ve just been through a period of malinvestment–we spent too much borrowed money on junk. Borrowing more to spend on junk only digs us in deeper.

Bank lending won’t get going again until trust in the markets can be restored. Fighting a Great Depression era problem probably won’t help. More transparency, which means more write-downs and failures, is probably necessary if we’re going to get through this.

I don’t think we know enough about the current situation to know if this is true, but it certainly could be. Unfortunately the recent accounting changes make it harder to find out, too. The Japanese lost decade certainly suggests that keeping failed institutions on life support is the wrong approach – but equally Lehman showed that letting firms fail in the wrong way is catastrophic for market confidence. We need banks to be able to prove to the market’s satisfaction that they are solvent, and prove that fairly soon. If the government recap gets us there, then fine. If not, even more drastic remedies are going to be needed.

Second, from an interview by Lord Turner in the FT:

Lord Turner said regulators would also now have to examine mark-to-market accounting, bankers’ bonus structures, the way in which financial institutions transfer risks, and the frameworks for regulating banks’ liquidity and capital.

He said the capital reserves imposed on banks last weekend were necessary to restore short-term confidence, and that the watchdog would have to work on a longer-term framework for setting capital.

He warned, however, that it could be some time before an international agreement could be reached. Some regulators believe it is necessary to scrap the Basel II framework, while others believe it can be adapted.

[Emphasis mine.] It is most reassuring to see that the new head of the FSA is willing to contemplate scrapping Basel 2. The Basel 2 capital regime has served us very badly: it’s pro-cyclical, imprudent in places and aggressively conservative in others, full of model risk, and far too complicated. Let’s start with a clean sheet of paper, and demand that the rules be simple, demonstrably prudent but fair across risk types (and accounting methods), and as little dependent on models as possible.

cut+me.jpg

Posted in: Basel, Mother of all Bailouts, Photography, Regulation by David /
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I have detected a slightly more sarcastic tone than usual in my recent posts and I had resolved to be nicer. But then something like this comes along:

The Basel Committee/IOSCO Agreement reached in July 2005 contained several improvements to the capital regime for trading book positions. Among the revisions was a new requirement for banks that model specific risk to measure and hold capital against default risk that is incremental to any default risk captured in the bank’s value-at-risk model. The incremental default risk charge was incorporated into the trading book capital regime in response to the increasing amount of exposure in banks’ trading books to credit-risk related and often illiquid products whose risk is not reflected in value-at-risk. At its meeting in March 2008, the Basel Committee on Banking Supervision (the Committee) decided to expand the scope of the capital charge to capture not only defaults but a wider range of incremental risks, to improve the internal value-at-risk models for market risk and to update the prudent valuation guidance for positions subject to market risk of the Basel II Framework.

The details are here and here.

What’s wrong with this? Well, at least three things. Firstly we still have VAR as the basis of market risk capital. Until Basel throws that out and comes up with something more prudent, probably based on stress tests, the Basel 2 market risk capital framework will rightly remain a laughing stock.

Secondly, not only have the supervisors kept VAR, they still believe that procyclical, miscalibrated risk models are a good idea, and they want more of them, even though they know banks cannot model the risks they are trying to capture:

Because a consensus does not yet exist with respect to measuring risk for potentially illiquid trading positions, it is anticipated that banks will develop different IRC modelling approaches. For example, a bank could develop a comprehensive asset pricing model incorporating both diffusion and jump processes for price movements over liquidity horizons

Finally, the proposed incremental capital charge is much higher for liquid, trading book assets than for held to maturity assets of the same risk profile in the banking book. That is simply wrong. So, Basel Committee, step away from the rule book: you have lost any credibility you might have had before the Crunch. Let’s start again, ideally with a different set of rule makers. Perhaps the white rabbit is free.

Posted in: Basel, Regulation by David /
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FT alphaville is I fear too tough on some of the European Commission’s proposals to alter the Capital Requirements Directive. There is in fact much to like about the Commission’s original approach (if not its subsequent pirouettes). The key section of the original is:

the originator credit institution shall calculate the risk-weighted exposure amounts … for the positions that it may hold in the securitisation. The risk-weighted exposure amounts for the originator credit institution shall not be less than [15%] of the risk-weighted exposure amounts of the securitised exposures had they not been securitised.

This is really good. It means that institutions cannot get rid of more than 85% of the capital, whatever they do, and so they are encouraged to keep at least 15% of the risk. I would feel happier with 25%, but 15% is a good start at ensuring alignment of interests.

Of course the objection to this is that – since this is an EU rather than a Basel proposal – it leads to a competitive disadvantage to EU banks. For here we get the Commission’s suggestion of a requirement that any originator keeps 10% of any risk if they want to sell to an EU bank. That, admittedly, isn’t a very sensible suggestion. The original proposal was just about portfolio credit risk transfer, not syndicated loans, not single name CDS. Rather than frantically making alternative proposals the Commission should stick to the original idea, and ideally try to persuade the Basel Committee to agree to it too. Capping regulatory relief on securitised exposure at 85% is sensible. Bravo Brussels. Now don’t stuff it up by panicing when the Banks say they don’t like it. They don’t have to like it. It just has to be the right thing to do.

Posted in: Basel, Capital and Contingent Instruments, Photography, Regulation, Securitisation and Tranching by David /
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Having said that Basel 2 was only for the 20 largest banks, and that those firms had to use the most advanced methods in Basel 2, the FED has backtracked. It is suggesting that the standardized framework would be available for banks, bank holding companies, and savings associations not subject to the advanced approaches. This is very interesting. Why the U turn I wonder? There is a story here, but I don’t know what it is yet

Update. Apparently WaMu and Wells Fargo, of the big banks, want to use the standardised approach. And the FDIC has swallowed its concerns and is supporting the roll out of Basel 2 to the smaller banks. This is really as shame. The FDIC was one of the few voices of sanity in the international regulatory `we haven’t got it wrong really oh no despite the biggest banking crisis in a generation’ hullabaloo. But as to why the FED won, I am still in the dark.

Posted in: Basel, Regulation by David /
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The FT reports:

International regulators and supervisors have started drawing up plans to make it far more expensive for investment banks to hold large volumes of complex financial instruments, such as mortgage-linked securities, in their trading books… though the Basel rules require banks to hold large capital reserves against the risk of credit default in their loan book, regulators only require small buffers for assets held in the trading book if these are labelled as low-risk, according to so-called Value at Risk models.

Up to a point your honour. Certainly there is a well-documented problem with the imprudence of VAR models, especially (but not only) ones which do not capture all the relevant risk factors. But the credit risk rules are not a shining example of prudence either, especially for low PD portfolios.

One need only compare JPMorgan’s capital allocation for market risk — $9.5B at Y/E 2007 — with its VAR — $107M — to see the problem with trading book capital based on VAR alone. But the solution is not to dump on structured products alone: it is to revamp the entire market risk regime.

Posted in: Basel, Regulation, VAR by David /
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Gillian Tett comments on the large supersenior ABS holdings at Merrill and UBS in the FT backed by mortgages on properties like the fine abode above:

Most notably, as these banks have pumped out CDOs, they have been selling the other tranches of debt to outside investors – while retaining the super-senior piece on their books. Sometimes they did this simply to keep the CDO machine running

Absolutely. And also as a funding arbitrage: for a bank that funds at Libor flat and views supersenior as risk free supersenior paying Libor plus ten is a good investment. Tett continues:

[Since] super-senior debt carried the AAA tag, banks were only required to post a wafer-thin sliver of capital against these assets

Again true, but I doubt that the advantageous reg. cap. position of these assets was that important. Any low volatility bond would do in a VAR setting, or any internally highly rated one under Basel 2 in the banking book. And there are plenty of AAAs that yield more than Libor plus ten. The real issue is the risk assessment: some banks managed to persuade themselves this paper was risk free. And that brings us nicely to an article in the WSJ on how exactly the firm got to that assessment. Enjoy.

Posted in: ABS, Basel, Photography, Regulation, VAR by David /
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On Wednesday the Basel committee announced some changes to the Basel II framework. The press release is fairly short on detail, but it does give some insight into the forthcoming detailed proposals. Let’s take a look.

The Committee reiterates the importance of implementing the Basel II framework.

This is shorthand for ‘please Mr. Fed would you implement our Accord?’

…the Committee will revise the Framework to establish higher capital requirements for certain complex structured credit products, such as so called “resecuritisations” or CDOs of ABS.

Clearly CDO squared products and CDOs of tranched ABS have been a major issue so this is reasonable. But CDOs of pass throughs have much less model risk and behave in a much smoother fashion so I hope these will not be tarred with the same brush.

It will strengthen the capital treatment of liquidity facilities extended to off balance sheet vehicles such as ABCP conduits.

The issue here is implicit support: legally many of these lines were low risk, but reputational concerns forced banks to provide support where it was not contractually required. Rather than charging for liquidity, which will simply encourage the use of non-bank liquidity providers, the committee should cap the benefit available for securitisation.

The Committee will strengthen capital requirements in the trading book… The Committee … is extending the scope of its existing proposal guidelines for “incremental default risk” to include other potential event risks in the trading book … (planned 2010).

This is so frustrating. The capital requirements in the trading book are already high compared with the banking book, and the incremental default risk proposals are hardly a model of cogency or risk sensitivity. If the trading book charges are imprudent then the banking book ones are far too low. They should also be revising the correlations in the IRB formula and increasing the risk weights for risk below BBB- in the revised standardised approach. And surely they can get their act together a little faster than 2010?

The Committee will monitor Basel II minimum capital requirements … over the credit cycle… [and] will take appropriate measures to help ensure Basel II provides a sound capital framework

So no discussion of procyclicality and no acknowledgement of the need for anti-cyclical capital requirements especially for fair value assets. This is disappointing. Basel II seems to have become a self-sustaining industry where wholescale change is almost impossible. The extended timeframes and modest revisions are evidence that major regulatory change will need more impetus than just the biggest banking crisis in a generation.

In July the Committee will publish for consultation global sound practice standards for the management and supervision of liquidity risks.

What about capital for liqudity risk?

Weaknesses in … valuation practices for complex products have contributed to the build-up of concentrations in illiquid structured credit products and the undermining of confidence in the banking sector. The Committee is taking concrete action to promote stronger industry practices in this area.

What pray might those be? If it doesn’t trade, it isn’t Level 1. Stronger practices whatever they may be need to acknowledge that fair value is often an estimate and that uncertainty in valuation will always be with us. This is fundamentally an investor education problem: equity holders suffer the same realised earnings volatility whether the asset is fair value accounted or not; hiding that volatility via loan loss provisions in the banking book just turns the spotlight away, it does nothing about the real risk. Supervisors seem to be aware of the issues with structured credit in a fair value context but reluctant to acknowledge that these risks are still there in an accrual context, just concealed by the accounting.

Are these changes going to help? A little, although putting a charity slot in the wall of the BIS might be more effective: there is much more that needs to be done, and done quickly.

Posted in: Accounting, Basel, Fair Value, Liquidity and liquidity risk, Photography, Regulation by David /
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Perhaps the most important part of Chapter 2 is a (mitigated) vote of confidence from the IMF in structure finance at the beginning:

Structured finance can be beneficial by allowing risks to be diversified

Before we get into the detail of the IMF report, that comment is worth noting. Now for the ‘but’s, or rather for my comments on selected ‘but’s.

• First a remark from the IMF about ratings: In particular, when reliable price quotations were unavailable, the price of structured credit products often was inferred from prices and credit spreads of similarly rated comparable products for which quotations were available. For example, the price of AAA ABX subindices could be used to estimate the values of AAA-rated tranches of mortgage-backed securities, the price of BBB subindices could be used to value BBB-rated MBS tranches. [...] In this way, credit ratings came to play a key mapping role in the valuation of customized or illiquid structured credit products, a mapping that many investors now find unreliable. This is important and has not received that much comment thus far. Many firms are currently marking a lot of ABS, some of it rather different from typical US subprime, as a spread to the ABX. They are doing this because they can’t think of anything better to do. But of course this only works if AAA ABX is comparable with AAA something else. So not only were ratings important for some purchasing decisions, they continue to be important for marking inventory. Which is scary.

• Credit rating agencies insist that ratings measure only default risk, and not the likelihood or intensity of downgrades or mark-to-market losses, many investors were seemingly unaware of these warnings and disclaimers. True, but really can we have a small does of caveat emptor please?
• Next a very sensible observation on fair value: Accounting frameworks require professional judgment in determining the mechanisms for fair value, including the use of unobservable inputs in cases of the absence of an active market for an instrument.

  Such judgment allows the possibility of different outcomes for similar situations, which in times of market uncertainty may compound the risk of illiquidity. As instruments turn illiquid moreover, they move from level 1 or level 2 of the FAS 157 hierarchy to level 3. The IMF notes that some people have drawn the wrong conclusion from this:investors seem to have a perception contrary to what the standard setters intended because a firm risks a negative market reaction with a reclassification of assets from level two to three, as events during the turmoil indicated.

• Reasonably enough, the IMF is concerned about SPV assets coming back on balance sheet at the worst possible moment, with no hint prior to that of the exposure. They opine:investors would benefit from more comprehensive regulatory requirements for disclosures about the scope and scale of exposures to OBSEs. [...] Increased disclosure achieved through consolidation or some form of parallel disclosures of an entity’s unconsolidated and consolidated positions also means these entities have a direct impact on the institution’s regulatory capital requirements, funding sources, and liquidity. (OBSE is IMF speak for SPV.) If this suggestion is taken seriously it will mean a huge change to IFRS. My sense is that the regulators will go further and faster than the accountants on this (not least because the accountants are saying “completing a final standard by mid-2011 will be extremely difficult, perhaps impossible”). Certainly caps on the regulatory benefit for securitisation are under active consideration.
• Will banks voluntarily take more of the OBSE’s assets onto the balance sheet to provide greater assurance to investors as to the vehicle’s quality? Only if that is the only way to get the securitisation market restarted and/or if regulators make them. Or should banks be required to retain a stake in the performance of these assets, thus having the incentive to conduct better due diligence? Yes.
• In general, variations in the regulatory treatment of securitization among different types of financial institutions may provide an opportunity for regulatory arbitrage across financial sectors. Some securitization exposures are evaluated for regulatory purposes differently for insurance companies than for banks. Finally in between congratulating themselves on the level playing field between banks someone in the supervisory community has noticed that the playing field between banks and non-banks is far from level. Basel 2 is flawed in many ways but it looks pretty good compared with insurance capital requirements for the monolines.
• Finally it is worth noting that the banks did not play the SIV and conduit game cynically: many of them seemed to have believed that risk really had been transferred. Or as the IMF puts it the perimeter of risk for financial institutions—that is, the risk assessment of all of an institution’s activities, including its related entities—did not adequately take into account the size and opacity of institutions’ exposures to SIVs, commercial paper conduits, and their related funding support. Given the size of the SIV and conduit activity, this failure of risk assessment is a big deal for the banking system.

Posted in: Accounting, Basel, Regulation by David /
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I have held off for a couple of days on commenting on this document not least because it is large, dense, and worth reading carefully. There is an awful lot of information in the full text here — the executive summary is here. In this post I will comment on chapter 1: posts on subsequent chapters will follow later in the week.

My tuppence ha’penny:

• The headline credit crunch loss predicted by the IMF of $1T has received a lot of press, not least because it is rather larger than the $460B some other commentators have been focussed on. Firstly no one really has any idea at this stage, and secondly it is half the estimated value destruction in the 1994 bond market crisis; so while it is a large number, we should not be too freaked by it.

• There is a lot of good information in the report. For instance this table showing the dependence of a number of European banks on wholesale funding, may be of use in selecting your next short. Just remember it is hard to make money shorting the Republic of France or its wholly controlled subsidiaries.

  

• According to the IMF there has been a massive rise in leverage of global banks. The report has this picture showing the growth of Bank assets and Basel 1 risk weighted assets, which I don’t understand.

  

  Here’s my problem. Consider the Basel 1 risk weights:
  

  Asset Class	Risk Weight
  Cash, Good quality sovereigns, Insured residential mortgages, short term commitments	0%
  Loans to banks and muni risk	20%
  Uninsured residential mortgages	50%
  Loans to banks and muni risk	20%
  All other loans	100%

  If assets are above 15T and RWA are at 5T the average risk weight is roughly 35%. How can that be given the preponderance of corporate and retail risk in the system? Remember RWA also includes derivatives risk which is off balance sheet and not included as an asset, so this number makes even less sense. If anyone can explain how the average Basel 1 risk weight for the banking system comes out at less than 50%, I should be very grateful. Certainly if the data above is correct, the IMF’s conclusion makes a lot of sense:

  Bank supervisors need to take more account of balance sheet leverage as they assess capital adequacy.

• The IMF seems to take a rather optimistic view of the effect of the credit crunch on the availability of credit. They forecast a slowing of the rate of growth of credit but not an outright contraction:
  

  The pace of credit growth in a squeeze would be reduced to a little over 4 percent of the outstanding private sector debt stock in the United States.

  I think that is wildly optimistic. Everything we are seeing from the retail and commercial mortgage markets, for instance, suggests that credit growth will be negative for the next half year at least.

• The IMF administers a richly deserved kicking to the monolines and their system of regulation:
  

  In the United States, the experience of the financial guarantors argues for reforms to U.S. insurance regulation.

  Responsibility currently resides with the states, which has impeded coordination of regulatory efforts across states and with federal bank and securities regulators where spillovers are now evident. A new strategy for regulation of the financial guarantor sector needs to be implemented, including a coherent approach to capital adequacy and new limits on financial guarantors’ activities.

Posted in: Basel, Economic Theory, Monoline, Regulation by David /
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We knew in the abstract this happens, but seeing it in the particular is chastening. From FT alphaville, discussing research from Credit Suisse:

Risk weighted assets and capital ratios under Basel I were relatively static. But that is unlikely to remain the case under the new variant. Risk weighted assets will move with the probability of default and the loss given default within a bank’s loan book. A required deduction for “expected losses” from capital will also mean more volatility.

The principles apply across a range of lending, corporate and unsecured, but it is the sensitivity of risk weighted assets to the UK housing market that has got Credit Suisse issuing this alert.

The note then goes on to look at HBOS. In what follows italics are the FT and bold is the FT quoting Credit Suisse.

The movements are significant. A 10% fall in house prices increases both the EL and mortgage risk weighted assets at HBOS by about 50% on our estimates. A 20% fall in prices more than doubles them.

In addition, RWA could also rise as older, lower LTV lending is replaced with new, higher LTV lending, they add, meaning an overall forecast for a rise of 60 per cent if house prices fall 10 per cent, in line with CS forecasts.

At a group level, this would lead to an increase in RWA of about 7%. Simply applying the increased EL and risk weight to the 2007 Basel II figures reduces the equity tier 1 ratio from 5.7% to 5.3%, on our estimates.

Ultimately Credit Suisse argues that the changes under Basel II mean that the market will start to react to movements in banks’ reported capital ratios. That, in their view, is the main threat to share prices, with the impact of an economic slowdown and house price slide on reported ratios becoming as important as that on profits in future earnings rounds.

Anti-cyclical capital ratios anyone?

Posted in: Basel by David /
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One possible counter to the problem of procyclical leverage I discussed earlier is countercylical capital requirements. Willem Buiter discusses these in his FT blog, and makes a few interesting suggestions.

1. Regulatory capital adequacy requirements should apply to all highly leveraged financial institutions. Just to get around the obvious wheeze of the treasury department of a bicycle manufacturer being turned into a de-facto financial intermediary, the capital adequacy requirements should be applied to any highly leveraged institutions, whatever its label.

Hmmm. This is slightly problematic because some of these firms, perhaps most of them by number, neither have deposit insurance nor pose systemic risk. Imposing capital requirements on smaller firms reduces the diversity of the financial system and encourages larger firms. I cannot see a fair way of shading between large/systemically risky/should have capital and small/systemically not risky/does not need capital, but certainly applying capital to everyone is not necessarily the best way of ensuring financial stability.

2. Regulatory capital adequacy requirements should be counter-cyclical – they should be raised (by the central bank) during periods of boom and lowered during periods of bust. This will also help remedy one of the problems with the Basel I and II Accords.

Absolutely. And the mechanism to do this is available under Pillar 2. FSA could easily, for instance, have cycle-dependent trigger and target ratios. This is possibly the single most important policy change we need.

3. There should be regulatory leverage ceiling for all highly leveraged institutions. This ceiling should again be varied countercyclically by the central bank: the ceiling will be lower during booms and higher during busts.

If regulatory capital makes sense then this will happen anyway under 2. One important issue is that at the moment off balance sheet leverage is not captured by capital: if you fix that and a few other loopholes, then 2. should imply 3.

4. There should be regulatory maximum liquidity ratios (say ratio of liquid assets net of liquid liabilities to total assets) for all HLIs. This ratio should again be varied countercyclically by the central bank.

Yes, but the devil is in the detail in defining liquidity ratios. For instance backup CP lines were thought to be very low risk until the crunch. Preventing arbitrage of these rules will need careful initial drafting and then regular review to ensure they remain relevant.

5. Maximum loan-to-value ratios for all collateralised borrowing (including mortgages). Again, these ceilings should be raised during a slump and lowered during a boom.

An excellent idea, although these LTVs will have to be asset class specific, and figuring out how to change them in a prudent manner will also require a lot of work. Step function changes might be problematic, so finding a function of macroeconomic variables which automatically determines today’s (or at least this month’s) maxLTV is important.

[...] My examples are not meant to be exhaustive, just illustrative. They share the feature that they don’t have Fed staff crawling through the darkened corridors of investment banks at night. They require verification that the various credit ceilings are respected, of course. But the ceilings themselves are varied according to macroeconomic conditions, not firm-specific circumstances.

Why wouldn’t you want the FED crawling through the banks at night, or indeed during the day? In particular, how can you ensure that a firm is doing the above correctly without supervision? The contract should be If you are a financial institution that either poses systemic risk, or can draw on central bank liquidity, or offers a product that is government insured (such as a bank deposit or certain kinds of insurance) then you have regulatory capital requirements and you are supervised.

Posted in: Basel, Capital and Contingent Instruments, Photography, Regulation by David /
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The Basel committee is meeting soon, unusually enough actually in Basel, although I suspect in a rather nicer hotel than this.

Gillian Tett discusses the gathering. The BCBS has a significant problem on their hands:

Thus the crucial question confronting the central bankers this weekend, as they fly in to snowy Switzerland is twofold: first, are we on the verge of a new downward lurch? And second, is there anything the G10 bankers can actually do to stop this?

The problem Tett identifies relates to mark to market:

But these days the US government faces a crucial impediment to repeating this trick. Back in the days of the S&L crisis, US banks were not forced to mark their books to the firesale prices. But now the mark-to-market creed has taken hold. And it is a fair bet that if US banks were forced to mark their books to the initial clearance price for a CDO squared, say, some would run out of capital. Hence the trap: in the modern financial system, you can have mark-to-market accounting systems, or quick action to establish clearing prices, but probably not both, without blowing up some banks.

That’s not hard to fix. Give a temporary waiver to the bank for capital calculations relating to these assets. Allow banks to move existing ABS securities and derivatives into the banking book for a short period, and let the banks know how long they have to get back inside the park. And don’t tell anyone you are doing it. That will restore confidence. Tett herself is skeptical that this is possible:

But I would be surprised if any action occurs soon.

Perhaps coordinated action is unlikely. But it would not surprise me if this was already happening.

Incidentally this brings out an interesting point. Do the regulators have the power to do this? They have complete power over regulatory capital, but not over accounting. I’m not sure if it would even, strictly speaking, be legal for a bank to move a fair value asset under IAS 39 into the banking book and not mark it. The regulators could permit the banks to ignore the deduction to Tier 1 caused by losses on these instruments, but the key difference is that these losses would still have to be published in the banks’ income statements. Perhaps that is something the central bankers should discuss.

Posted in: Accounting, Basel, Regulation by David /
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It is far too early to pronounce the bloated body of Basel 2 dead, but at least the patient is ailing. In the FT Harald Benink and George Kaufman have some suggestions:

First, we urge the Basel committee to conduct another quantitative impact study using observations from the recent turmoil before allowing banks to use their internal models for calculating regulatory capital.

That’s a good idea, but remember that Basel 2 is not based on bank’s internal models. It is based on bank’s ratings, which then go into the supervisor’s formula. It is the supervisors who are at fault for any capital underestimate, not the banks.

Second, we advocate the additional adoption of a meaningful non risk-weighted leverage ratio requirement, as currently applicable in the US, to supplement Basel II risk-weighted capital requirements.

There is a (tiny) constraint already in Basel 2, in that PDs have a 0.03% floor. But the suggestion is a good one – a crude leverage ceiling would act as an additional control.

Third, we recommend that the Basel II approach using banks’ own risk models should be complemented by a credible and effective form of market discipline.

I remain unconvinced that this will help much. It can’t hurt, but I’m afraid that greed will outweigh fear most of the time despite the reasons to be scared that might be known.

Let me add in a few more ideas.

Fix the procyclicality of Basel 2. A risk sensitive Accord is necessarily procyclical. There is no way around this. And procyclicality is likely to intensify the depth and intensity of asset price bubbles and recessions. Basel 2 is based on one year PDs. Instead it should be based on across the cycle PDs.

Fix the incentive for less advanced banks to take the worst risks. The menu of approaches in Basel 2 makes it more expensive for advanced banks to take high PD exposures vs. standardised approach banks. Unlike VAR, which gives a reduction in capital for pretty much any market risk portfolio, the IRB is only cheaper than the standardised approach for better quality assets. This creates a perverse incentive which should be addressed.

Fix the IRB formulae. The correlation assumptions are just wrong, as is the assumption of constant default correlation. Based on the suggested QIS, they should be rewritten with much more conservative default correlation assumptions.

Cap the benefit for getting assets off balance sheet either via securitisation or into a conduit. This preserves alignment of interest and again acts as a cap on leverage.

Posted in: Basel, Regulation by David /
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The financial stability forum working group on the crash has produced an interim report. It is an insightful document as it gives some clues about the regulator’s thinking (and lack thereof). I will focus on the suggested areas of action at the back of the document: the first part discusses the causes of the crash, and that is rather old ground.

1. Supervisory framework and oversight
Capital arrangements: A resilient framework for capital requirements is central to creating appropriate capital buffers in the system and the right incentives for risk management. The implementation of Basel II, and the use of its three reinforcing pillars, is an important step to achieve this.

I read that with a heavy heart. Basel II is fatally flawed, as a number of authors have demonstrated, and just pressing on with it is tantamount to fiddling with Rome burns.

The Basel Committee will take account of the lessons from recent events and assess whether refinements to the Basel II framework are needed, including with respect to the calibration of certain aspects of the securitisation framework.

It is not just the securitisation framework. It is the entire philosophy behind and calibration of the accord. Remember that residential mortgages were one of the bigger winners in Basel II. Remember that ratings are central. Remember the bizarre behaviour of the IRB formula. The supervisors need to start again.

The turmoil has demonstrated the need for larger and more robust liquidity buffers and an internationally shared view among supervisors on sound liquidity risk management guidelines.

How about capital for liquidity risk? Or if the regulators are not willing to go that far, they will at least have to say what they mean by an adequate liquidity buffer. How would you work out how much is enough?

Firms’ managements need to act proactively in response to stress test results.

This is the hardest thing for a supervisor – forcing firms to conduct stress tests is easy. Forcing them to respond to the results of them is much harder. How exactly are they going to require firms to act without taking over management’s role?

Off-balance sheet activities: Basel II strengthens incentives in the financial system to manage risks appropriately and will reduce the regulatory arbitrage that generated large off-balance-sheet risk exposures.

Basel II just creates different regulatory arbitrages, at least as currently drafted. Putting a cap on the benefit from any securitisation would be easy first step towards removing those, but the suspicion is that the supervisors are mired in attempts to revise the already complex language of Basel II without seeing the bigger picture. Off balance sheet vehicles are fine provided they are genuinely off balance sheet and there is no implicit support. The problem is that supervisors currently have a set of rules which is penal with regard to genuine risk transfer and laughably generous with regard to sham transfer. Until they can figure out which is which any attempt to revise the rules is likely to damage perfectly reasonable trades.

2. Underpinnings of the originate-to-distribute model
The underpinnings of the OTD model – including origination and underwriting standards, transparency at each stage of the securitisation process, the role and uses of credit ratings – need to be strengthened. [...]

This paragraph is motherhood-and-apple-pie. Pious hope may be necessary, but so are concrete proposals.

3. The uses and role of credit ratings
Investors, many of whom have relied inappropriately on ratings in making investment decisions, must obtain the information needed to exercise due diligence.

Investment guidelines should recognise the uncertainty around ratings an differentiate products according to their risk characteristics.

Yes, but you don’t regulate many of the investors, so while this is true it does not amount to a mug of beans.

CRAs must clarify and augment the information they provide to investors on structured finance products. They should ensure that uncertainties surrounding their models and rating methodologies are made transparent. We welcome that CRAs are considering differentiating ratings of such products from corporate ratings. [...]

That is a reasonable idea but it is hard to see how to standardise model risk disclosure. The concern will be that these disclosures will turn out to be boilerplate text rather than a real attempt to analyse the sensitivity of a securities’ value to the choice of model.

CRAs need to take adequate steps to address concerns about potential conflicts of interest, including concerns about their remuneration models.

Clearly. That bullet is going to be very difficult for the agencies to dodge.

4. Market transparency
Financial institutions need to improve the usability of disclosed information about risk exposures and valuations, including those related to structured products and off-balance sheet vehicles

Again, the industry has proved adept at making disclosures that meet the required standards but don’t actually disclose much useful information. Just look at the memo accounts for any big investment banks. So while one can sympathise with the idea of more transparency, it will need very careful management to be effective.

Further improvements are needed in firms’ valuation methodologies and in the data that they use as inputs to their valuation processes, in particular when markets are illiquid.

You can’t improve the view in a mist. Valuation in the presence of size issue, liquidity issues, or model risk is inherently uncertain. Instead the users of financial statements need to be aware of that uncertainty, and we need to develop ways of quantifying it.

5. Supervisory and regulatory responsiveness to risks
Supervisors, central banks and financial authorities – individually and collectively – need to become more effective in translating risk analysis into action.

The point above applies. It is easy to say this. What are you going to do to make sure that this action actually happens?

6. Authorities’ ability to respond to crises
Central banks’ operational frameworks must be able to supply liquidity effectively when markets and institutions are under stress. Central banks are actively investigating what lessons they can draw from recent experiences for their operational frameworks, including the capacity to provide liquidity broadly and flexibly under stressed conditions, for their communication with markets, and for the steps that might be advisable across central banks to address liquidity needs in globalised financial markets.

All of this is a little depressing. It feels as if the FSF is flailing around at roughly the level of an undergraduate seminar. We are going to need more than a bit of disclosure, a wider range of collateral at the window, and management promising on the life of their favourite pet that honestly they will take action if risk gets too big to get us out of this mess.

Update. The FT uses the FSF paper as a launchpad to discuss the broader lessons of the crunch here. Meanwhile Larry Elliott in the Guardian makes the interesting point that the FED, the ECB and the Bank cannot all be right about rates. I might get to that on Wednesday.

Posted in: Basel, Liquidity and liquidity risk, Regulation, Risk Management by David /
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John Dizard wrote a provocative article for the FT recently. He discussed what amount to little more than a rumour, albeit possibly a well informed one, about the views of leading regulators and central bankers concerning the future of securitisation.

The official [central banking] world, and those close to it, are anticipating that we’re going back to an on-balance-sheet financial industry. That is, the extension of credit will be done, to a much greater degree, through direct lending by depository institutions rather than through the securitisation of structured products. The frenetic expansion of securitised and, it was supposed wisely distributed, risk turned out to be not quite so wise after all.

The problem with putting credit on bank balance sheets is that those balance sheets aren’t big enough to cover the losses from past practices and to continue to expand credit at an adequate pace. Shareholders’ equity and reserves aren’t there, at least in the necessary size.

Very true, the central bankers will say. So we’ll just have to get some new shareholders. The “real money investors” are there, and not just the sovereign wealth funds. What about the present shareholders, I ask, my face turning white? As Colbert memorably said: “A banker is a soldier in the service of the state.” So perhaps the rally in bank shares might be a little premature. The central banking world is expecting a serious shake-out of individual and perhaps institutional participants.

This is worth examining in some detail. First, how could central bankers compel or at least strongly suggest to banks that they desist from securitisation? Presumably without any changes at some point the securitisation market will come back – indeed some MBS deals have been done already this year. So to rein in what they evidently see as the Gorgon, the central bankers will have to do something. The only available policy lever is regulation: capital charges will have to go up markedly to throttle off demand.

Note too that there are different reasons for banks to use the securitisation market, some of them less toxic than others. At the benign end of the spectrum selling the AAA to get sub-Libor funding on an opportunistic basis (and obviously not assuming that this can be done as part of your funding strategy) is natural for smaller banks. Without it, the barriers to entry get even higher and the benefits of consolidation more significant: do we really want more banks which are too big to fail?

On the other hand, clearly supervisors have a vested interest in preventing regulatory capital arbitrage via securitisation. Basel 2 does not do this: it simply introduces new arbitrages from the ones available under Basel 1. There are fewer of them perhaps but they are still there.

The final motivation for securitisation is pure arbitrage. Sometimes the assets really are worth more in securitised form. This may be because they are illiquid, hard to originate, or hard to assess. Institutions with an edge, be it origination or market knowledge/credibility, can legitimately exploit that. Remember too that securitisations are like blenders: they can liquidify previously illiquid assets. That in itself can make them more valuable.

Could one hope that the supervisors will continue to permit the good securitisation yet design rules which make the bad more difficult if not impossible? It seems unlikely. If there is any wiggle room at all in the rules the industry will find it. So to be sure of banning the bad kind of securitisation it is likely that the rules will end up disincentivising the good kind too. If Dizard is right, then, Basel 3 will tend to favour large banks with a low cost of funds and plenty of capital.

The next part of the problem is that there are not too many of those left. So most banks will be forced to scale back on risk taking while they rebuild capital and delever. The consequences of that for the G10 economies will be profoundly negative: credit in all forms will become much harder to obtain, market making will be less practiced and hence liquidity will decrease, and growth will slow. Banks are too addicted to securitisation to go cold turkey without the detox effecting the broader economy. Instead I suggest central bankers should be looking at something more like nicotine patches: get rid of the most harmful form and manage dependence without generating too much discomfort. An over-reaction, however, seems most likely.

Posted in: Basel, Regulation, Securitisation and Tranching by David /
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The FT asks a question:

A fundamental question therefore arises: is the financial system broken, corrupt and in need of reform; or is the system sound, yet subject to external pressures, notably heavy monetary stimulation, with which it could not easily cope?

Roger Ehrenberg has an answer:

Is the financial system somewhat broken and in need of reform? Absolutely. But is the increasingly liberalized system in place today an essential element of a healthy, integrated and global financial marketplace? I think the answer is also a resounding yes. So where have things broken down, and what can we do to fix them? Here are some ideas:
1. Increase transparency among regulated institutions
2. Homogenize global accounting standards
3. Homogenize global regulatory frameworks
4. Aggressively strip conflicts of interest out of the system
5. Clarify the roles and responsibilities of fiduciaries
6. Develop common sense compensation policies and practices

Let’s examine these one by one.

1. Increase transparency among regulated institutions
Accounting disclosure of derivatives is pretty much useless. Even with Basel 2 the disclosures on market risk in general are only marginally more useful: the VAR typically tells you little. We need more useful disclosure on market risk, liquidity risk, off balance sheet risk and credit risk mitigation.

2. Homogenize global accounting standards
I don’t see this as pressing. Standards are coming together already and while significant differences remain, they are not nearly as important as the things you get no information about from financial statements. See 1. above.

3. Homogenize global regulatory frameworks
Yes, but the issues are mostly not between banks in different countries but rather between banks and non-banks in the same country, notably between banks and insurers but also between banks and broker/dealers. The monolines would never have been able to get into their current state if they had been regulated under Basel 2.

We also desperately need to fix the market risk capital regime. I have talked about this before so I won’t go over old ground: suffice it to say, VAR is no longer a useful measure of market risk capital (if it ever was).

4. Aggressively strip conflicts of interest out of the system
This is definitely right. Legal and regulatory steps to align interests are necessary as clearly the buyers of securities either couldn’t or wouldn’t do the job.

5. Clarify the roles and responsibilities of fiduciaries
What Ehrenberg means is that if you give your cash to someone with the mandate to manage it conservatively and preserve capital, and they buy a Libor + 40 AAA floater that subsequently defaults, you should have someone you can sue. Certainly the idea that a rating substitutes for due diligence is bizarre and it should not be defensible in court. But right now it probably is.

6. Develop common sense compensation policies and practices
This is just a variant of 4. The way people are paid should not set up a conflict of interest between shareholders and the risk takers they pay, nor between those risk takers and the broader financial system.

Conclusion
I do not believe that the credit crunch was brought about chiefly by malevolence or bad faith. Of course there was some of that, but mostly it was a series of small incentive structures combining to produce a systemically disastrous result. Hence we need to fix the rules of the game to produce better incentives.

Posted in: Accounting, Basel, Monoline, Ratings, Regulation by David /
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One of the few resonant sentences in the new Basel Accord – a document which mostly reads as if it were written by a committee (as it was) – concerns commercial real estate:

In view of the experience in numerous countries that commercial property lending has been a recurring cause of troubled assets in the banking industry over the past few decades, the Committee holds to the view that mortgages on commercial real estate do not, in principle, justify other than a 100% weighting of the loans secured.

Right on cue, CRE is again springing into the prescribed line as a cause of troubled assets. The Economist points out:

From up high, London is a picture of vigorous renewal. In just about every direction, construction cranes point contemplatively to the skies. They also point to the great boom that has taken place in commercial property in recent years. The collapse of that boom, which now threatens to slash the values of these gleaming office towers and destroy the savings of millions, may pose almost as great a threat to Britain’s banking system as the subprime crisis that has been roiling financial markets since late in 2007.

What is interesting is the extent of the downturn indicated by the IPD forwards. These provide an indication of where commercial real estate derivatives market participants are willing to trade on a forward basis – and they forecast a 30% fall over the next three years. Thirty, not three. That’s one thing Basel got right then…

Posted in: Basel, Markets, Mortgages by David /
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Sheila Bair, chairman of the Federal Deposit Insurance Corporation, is trying to wake her fellow supervisors up to the issues in the internal models approaches to capital in Basel 2. She is reported to have said:

Current financial market turmoil has shown up the weaknesses of the models used in the advanced approaches to assessing credit risk under the international Basel II bank safety rules…

The first lesson of the crisis in terms of the Basel II capital adequacy rules is “beware models!”

Bair is right of course. The models are necessarily inaccurate, since calibration is problematic, procyclical, and tend to support asset price bubbles.

The weaknesses “startlingly revealed” in the Basel II models by the turmoil “are a very bright, flashing yellow light warning us to drive very carefully,” …

The FDIC chairman has previously expressed doubts about what she has described as the “untried” risk models underlying the advanced Basel II approaches that banks can use to assess their credit and operational risks and determine the minimum capital they need absorb shock losses.

Remember just because it backtests for some period doesn’t mean it is right. A stopped clock backtests well in the few seconds around the time it is stopped at.

Update. The Telegraph (yes, I know, but I couldn’t find a reference from a reputable paper in a hurry) carries a report on a slightly alarmist but interesting speech from Peter Spencer of the Ernst and Young Item Club. Spencer says that the Basel 2 rules

..are the root cause of the crunch and were serving to worsen the City’s plight.

Dismissing the assumption that banks are not lending to each other on the money markets because they lack confidence in each others’ potential solvency, he argued that they were, in practice, prevented from lending the cash at all because it could leave their balance sheets falling foul of the Basel regulations.

Presumably the idea is that now lines of credit below 364 days are not free in capital terms, banks are rationing capital and hence not lending. This seems unlikely, especially as the capital usage of short term interbank lending is low. I wonder what evidence Spencer has.

Posted in: Basel, Model risk, Regulation by David /
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I don’t think the answer to the title question is clear. But some desireable criteria are becoming apparent. I suggest:

• At any point in time, larger risk should imply larger capital, i.e. there should be portfolio risk sensitivity.
• Overall, market wide changes in risk premiums (and in particular market crises) should not change capital requirements.
• An element of capital should depend on stressed liquidity, i.e. how liquid the institution’s assets are in a crisis.
• Only limited capital reduction should be permitted for risk transfer of assets originated by the institution. This ensures alignment of interests and reduces the total amount of risk leaving the regulated financial system.
• Transactions which reduce capital without reducing risk should (ideally) not be possible or, if they are, forbidden by other means. Regulatory capital arbitrage should not be counternanced.
• Incentives should not exist for risk to move from more advanced banks to less advanced ones. The menu approach for credit risk does this at the moment in Basel 2: standardised approach banks have lower capital charges for the worst quality borrowers than IRB banks. Internal models approach should always give the same or (slightly) lower capital than standard rules in order to preserve the incentive to meet the standards for internal modelling.
• The capital regime should incorporate larger charges for assets of uncertain value (level 3 assets in the FAS 157 hierarchy) and lower ones for level 1 assets.

Posted in: Basel, Markets, Regulation by David /
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This table is from QIS5, the 5th (and latest) quantitative impact study into the effects of the new Basel Accord. Since Basel 2 was approved recently in the U.S. (markedly behind much of the rest of the world) I thought I would commemorate the date by looking at the effects of Basel 2.

Group 1 are the largest banks: Group 2 are somewhat smaller. What we see here is the impact on minimum capital requirements (MRC) of the various new rules. The big winner for both classes of banks is retail mortgages: these contribute falls of 7.6% and 12.6% respectively in total capital required. And which category of business is causing a massive credit and liquidity crunch, endangering institutions from banks through broker/dealers to bond insurers and money market funds? Oh, retail mortgages.

Update.Alea has a nice set of links and discussion on the procyclicality of the New Accord. I’m still not convinced that regulatory capital is that big a motivation unless it is scarce, but still the incentive structures in Basel 2 cannot be helping matters right now.

Posted in: Basel, Mortgages, Regulation by David /
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Short of green men landing in the City and eating everything within a mile of Bank station, how serious could the credit crunch get, given what we know? The following is not a prediction, more of an exercise in generating plausible worst case scenarios.
Firstly the possibility of the failure of a systemically important institution cannot be ignored. The rumours surrounding further write-downs are too pervasive for that. Undoubtedly a rescue would be organised, but confidence would be very severely shaken and massive injections of liquidity would be necessary to stabilise the markets.

In this context we could expect a series of hedge fund failures too, and a widespread deleverage and flight to quality across the system. Significant falls in equity markets, moves in low yielding currencies vs. the dollar (as carry trades are unwound) and spikes in implied volatility are also to be expected. The securitisation markets would remain shut for an extended period of time, ABCP would be very difficult or impossible to roll, and the swap spread would go out significantly.

Another possibility is the failure of a monoline (such as MBIA, Ambac, FGIC, FSA or Radian) or a large insurance company involved in the credit markets such as Ace or XL. This is more problematic in that the parties who would be involved in a rescue are less clear and the majority of the systemic risk related to such a failure would be confined to the wholesale market. On balance though in the circumstances I think a rescue would be more likely than not. We have not seen a failure like this before so the consequences are harder to predict, but certainly the impact on the muni and structured credit markets would be considerable.

We can reasonably assume that the largest firms have the resources to attempt to mark their books. For smaller banks or fund managers that may not be the case, so there could well be medium sized institutions that are sitting on losses that are significant given their capital base without knowing it. This won’t be as bad as a big player going down, but on the other hand a struggling tiddler might actually be allowed to fail, depending on the country. That would cause further spread widening and deleverage across the industry.

Just as Sarbannes Oxley was a (-n over) reaction to Enron, so we can expect to see revisions to Basel 2 and to the accounting framework for conduits and SIVs. These will be a slow burn rather than sudden changes, in all likelihood, but depending on how far they go, they have the potential to reduce the intermediation of risk and decrease bank profitability, at least until the industry figures out how to arb the new rules.
Meanwhile we can expect the U.S. housing market to trend down for an extended period, until mid 2009 at the earliest, and contagion into other bubbly markets such as the UK and Spain is entirely possible. Specialist mortgage lenders, REITs, builders, and the holders of 2006 and 2007 vintage MBS paper are likely to suffer most. The impact on the economies concerned will be considerable, and full blown consumer-lead recessions are entirely possible in the U.S. and the UK.

The equity markets seem particularly vulnerable at the moment: perhaps we are seeing the start of an inevitable repricing of risk, but with many established equity markets close to their all-time highs, large falls from here are possible. Bank debt must also be vulnerable: while spreads have blown out, they are still rather tight compared with the potential downside in some of the scenarios I have outlined. This will have a knock-on effect in credit markets generally as risk capital is withdrawn and investors become much more risk averse.

None of this is inevitable, or even — so far at least — likely. But looking at what the future might bring is always a useful exercise, particularly in the heat of a crisis. Look on my stress tests, ye Mighty, and despair:

• Failure of your largest (by notional or PFCE) bank counterparty.
• One day equity market fall of 25%, followed by a further 40% over six months. Private equity cannot be sold.
• Short rates go to 2%, long rates to 6%, and the swap spread is 100 bps.
• Interbank borrowing is impossible for three months. Securitisation is impossible for ever.
• One day dollar fall of 5% followed by a further 20% over six months.
• All asset-backed securities except RMBS become completely illiquid and halve in value. (Remember this has an effect on collateral from clients and on SIVs and conduits too.)
• Default rates on prime retail mortgages are the worst ever experienced historically plus 10%. Subprime assets are worthless.
• AA- or better credit spreads for financials go out 100 bps. 150 bps for A to BBB. 300 bps below that. Corporate spreads go out by half those amounts, as do emerging market spreads. (Or if you want a riff on this, BRICS spreads tighten.)
• All monoline or credit insurer protection is worthless. Monoline spreads are 500 bps.
• All hedge funds concentrating in ABS default. Default probabilities triple for the rest.

Posted in: ABS, Basel, Markets, Worst case scenarios, Writedown by David /
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A capital model creates an incentive structure: if a firm’s estimate of the capital required to support its business rises, then that implies it is taking more risk. At some point increasing risk becomes unacceptable given the firm’s desired soundness standard, and so positions are cut.

Recently there have been some discussion by Gillian Tett in the FT (quoted by Naked Capitalism) of this effect with regard to VAR models. The basic problem in VAR is that risk estimates can increase either because the portfolio has changed or because market volatilities and correlations have increased. Thus with a regularly updated VAR model the same portfolio in a crisis produces a higher capital charge and hence banks are incentivised to cut at the worst moment. Similarly risk estimates are lower in calm markets, encouraging banks to over-leverage.

The effect can be significant. As Ms. Tett points out

[The Bank of England] estimated that a typical bank’s VAR might theoretically double, with the same assets, if volatility increased.

A similar problem occurs in Basel 2 IRB models – in an economic downturn, banks’ estimates of PD and LGD rise, increasing capital, and so discouraging lending. This may intensify the intensity and duration of the downturn.

The phenomenon is known as pro-cyclicality, and it is clearly undesireable. One problem here is that regulators have confused two different kinds of risk sensitivity. Clearly at any point in time having a larger capital estimate for a riskier portfolio than for a less risky one is a good thing: let us call this portfolio risk sensitivity. (Basel 2 doesn’t completely satisfy this either, but we will ignore that for the moment.) Then there is temporal risk sensitivity: here the risk estimate of the same portfolio changes over time as market factors used as inputs to the capital model change. It is much less clear that complete temporal risk sensitivity is a good thing. Using long term average inputs to VAR or IRB models might produce better incentives than short term current market estimates. Such models would have the helpful (in a crisis) property of failing to respond quickly to changes in market conditions.

It might be argued that this means that banks are under-capitalised during tough markets. That would be a reasonable argument if VAR produced capital estimates which reflect possible losses in these markets – but it doesn’t (and it was never designed to). One needs only examine Morgan Stanley’s latest 10-Q to see the phenomenon: their VAR was very roughly $100M yet they suffered a one day loss of $390M. This does not mean that their VAR is broken: VAR is not intended to give an account of how big losses might potentially be. But it does illustrate that modern trading activities can generate losses far in excess of VAR capital estimates, and hence that other risk measures such as stress tests are important too. This relegates VAR to its proper place, as one risk measure amongst a number. In this setting market risk capital would not be based on the VAR alone, and shows that there is no need to have overly temporally risk sensitive capital estimates.

Posted in: Basel, Regulation, VAR by David /
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From Bloomberg:

“Moody’s does not structure, create, design or market securitization products,” Kanef [group managing director, asset finance group, Moody's Financial Services] said. “We do not have the expertise to recommend one proposed structure over another, and we do not do so.”

Update. After that confidence building statement, we have the FT reporting that a senior U.S. official is considering splitting up the advisory and ratings functions of the agencies to reduce their conflicts of interest. It will be interesting to see if there is a knock-on effect to Basel 2 here: after all, ratings are at the heart of the new Accord, and now it is clear how untrustworthy they were in some cases, the supervisors might have a change of heart.

Posted in: ABS, Basel by David /
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It will be very interesting to see how bank supervisors react to the current credit crunch in the longer term. We are less than a year into the new Basel 2 Capital Accord, and already it looks flawed in a number of areas. This is hinted at in the FT today. At very least in the UK we will see a revision of the deposit protection regime. But (admittedly in the heat of the battle and without mature reflection) Basel 2 looks vulnerable too, especially in the areas of credit risk mitigation and the treatment of off balance sheet vehicles.

A related issue is the procyclicality of Basel. This has been around for a while in the context of VAR models (asset prices go down, vols go up, so VAR goes up, pushing banks over their risk limits and hence causing asset sales which further depress prices), but Basel 2 extends this to the banking book via bank’s PD estimates in IRB models. The problem is, risk sensitivity goes hand in hand with procyclicality. It will be interesting to see if the supervisors can bring themselves to make Basel 2 less risk sensitive.

Here’s a view towards Canary Wharf from the City of London.

Posted in: Basel, Financial Models, Regulation by David /
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There were some interesting remarks from James Hamilton at the FED Jackson Hole meeting. My favourite part is:

The instrument of monetary policy that we tend to think of first is the time path of short-term interest rates. It’s natural to start there, because it’s easy to quantify exactly what the Fed is doing.

But another instrument of monetary policy that I think needs to be discussed involves regulation and supervision of the financial system.

That certainly fits with the theme of this blog – that the rules of the game determine the dynamics you see, and you need to engineer the rule set carefully to get the right type of behaviour (and stop the wrong type, whatever right and wrong mean).

Naked Capitalism (where I picked up the report) talks about this in the context of the large complex financial institutions – the Bank of England’s term for the largest most systemically important firms (of which it identifies 16).

This graph from the Bank’s Financial Stability Review is quoted there:

What we see in the large is rising assets and (assuming asset quality remains roughly constant, which might well not be true) decreasing credit quality. Certainly leverage is increasing. Basel II is likely to make this worse if the results of the quantitative impact studies are to be believed, and the increasing prevalence of SIVs and conduits to get assets off balance sheet is not helping either. Stepping away from the details of risk sensitivity, the level playing field and so on, is the regulation of large complex financial institutions heading in the right direction if they are getting larger and their leverage is increasing?

The 16 LFCIs include Barclays, ABN AMRO and RBS, so if ABN is taken over by either of its two current suitors, the 16 will become 15. Are a smaller number of larger, more complex firms more or less systemically risky than a larger number of smaller, less well capitalised ones?

Posted in: Basel, Regulation, Rules, SIVs and Conduits by David /
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