Deus Ex Macchiato

FED governor Daniel Tarullo gave an interesting speech recently; interesting because he is clearly trying to set out a regulatory agenda while uncomfortably aware that legislators, if anything like Brown Vitter is passed, might pull the rug out from under him. He therefore has to tread delicately. That doesn’t stop him from pushing the FED’s line, but they are gentle nudges.

His first real point is that liquidity reform has not made much progress:

we have not yet adequately addressed all the vulnerabilities that developed in our financial system in the decades preceding the crisis. Most importantly, relatively little has been done to change the structure of wholesale funding markets so as to make them less susceptible to damaging runs… But significant continuing vulnerability remains, particularly in those funding channels that can be grouped under the heading of securities financing transactions.

He has to admit that little has been done about too big to fail as it hasn’t, and the Senate has noticed

With respect to the too-big-to-fail problem, as I noted earlier, actual capital levels are substantially higher than before the crisis, and requirements to extend and maintain higher levels of capital are on the way… But questions remain as to whether all this is enough to contain the problem.

Indeed. He gives the standard spiel on more capital and/or liquidity risk regulation, as in Basel III. But then it gets interesting:

a second possibility that has received considerable attention is a universal minimum margining requirement applicable directly to SFTs.

Or, for that matter, a tax on them. Either would do.

Look at this for a lovely piece of politics. Tarullo says, as he would, that the FED should be allowed to complete its current agenda. But then he pays deference to the law makers:

the first task is to implement fully the capital surcharge for systemically important institutions, the LCR, resolution plans, and other relevant proposed regulations. But, completion of this agenda, significant as it is, would leave more too-big-to-fail risk than I think is prudent. What more, then, should be done? As I have said before, proposals to impose across-the-board size caps or structural limitations on banks–whatever their merits and demerits–embody basic policy decisions that are properly the province of Congress

That leads him to trying to head the B-V posse off at the pass:

One approach is to revisit the calibration of two existing capital measures applicable to the largest firms. The first is the leverage ratio. U.S. regulatory practice has traditionally maintained a complementary relationship between the greater sensitivity of risk-based capital requirements and the check provided by the leverage ratio on too much leverage arising from low-risk-weighted assets. This relationship has obviously been changed by the substantial increase in the risk-based ratio resulting from the new minimum and conservation buffer requirements of Basel III. The existing U.S. leverage ratio does not take account of off-balance-sheet assets, which are significant for many of the largest firms. The new Basel III leverage ratio does include off-balance-sheet assets, but it may have been set too low. Thus, the traditional complementarity of the capital ratios might be maintained by using Section 165 to set a higher leverage ratio for the largest firms.

The other capital measure that might be revisited is the risk-based capital surcharge mechanism. The amounts of the surcharges eventually agreed to in Basel were at the lower end of the range needed to achieve the aim of reducing the probability of these firms’ failures enough to offset fully the greater impact their failure would have on the financial system. At the time these surcharges were being negotiated, I favored a somewhat greater requirement for the largest, most interconnected firms. Here, after all, is where the potential for negative externalities is the greatest, while the marginal benefits accruing from scale and scope economies are hardest to discern. While it is clearly preferable at this point to implement what we have agreed, rather than to seek changes that could delay any additional capital requirement, it may be desirable for the Basel Committee to return to this calibration issue sooner rather than later.

Is this just trying to kick the can down the road? Tarullo must know his chances of getting higher standards agreed in Basel are low. Equally he knows that unilateral action in the US will damage the competitiveness of US banks (while making them safer, of course). If he can’t persuade the Brown-Vitter crew to back off, and he can’t get Basel to agree to similar standards, he will have to doff his cap and do what the law requires. I would suggest, though, that that doesn’t mean that he will like it.

Posted in: Liquidity and liquidity risk, Regulation by David /
2 Comments

…can be found here.

You might think that B-V is impossibly strict and hence impossible to pass, but there is the core of a good idea in this bill, and it would be dangerous to dismiss it entirely. A slightly gentler B-V with phased implementation (say, a simple leverage ratio rising from 3% to 12% by 1% a year starting 2015 for the mega-banks) is entirely feasible. (Whether it would be wholly positive for financial stability or not is another matter.)

Posted in: Regulation by David /
3 Comments

Karl Smith has a theory:

… lets imagine a simple model where we have two sources of risk. There is background you cannot avoid. And, there is personal risk that you create by through your own choices.

Policy makers have since Thomas Hobbes been attempting to drive down background risk. They have larger been successful. As a result our lives are getting more and more stable.

As that happens, however, folks are going to tend to take on more personal risk. There is a tradeoff between risk and reward. As you face less background risk, for which you not rewarded it makes sense to go for more personal risk for which you are rewarded.

When I take on more personal risk, however, it bleeds over slightly into everyone else’s background risk. People depend on me. If I take risks and lose so big that I debilitate myself then my family and my friends will surely suffer. But, so will my employer, my creditor and the businesses who count on me as a regular. When I go down, they go down.

So, putting it all back together and we come up with something of a risk floor, if you will.

Now, I should say at once that I don’t wholly buy this. But it is an interesting idea, and there is some evidence to support it. For instance, Australian research on compulsory cycle helmets suggests that cyclists that feel safer as a result of their helmet take more risk, resulting in little change in cyclist mortality* despite the new policy. However, it is not obvious that we can generalise from evident physical danger to financial risk.

Suppose we can though. That would mean, as Smith implies, that risk reducing policies can, if we are near the floor, cause risk to pop up again in a form that might be harder to spot. That suggests that a polluter pays approach, where we try to charge for the risk being taken rather than prevent it. Direct fees to price systemic externalities, then, rather than capital to prevent them. One might imagine that if FDIC deposit insurance fees were truly fair, then they would comprise a floor element plus a systemic surcharge (which was at least quadratic in bank size). Such an approach would attempt to charge for the cost of failure rather than capitalising the risks that might lead to it. As I say, I’m not necessarily recommending it, just suggesting that it is an interesting alternative.

Such laws are however good at discouraging cycling.

Posted in: Regulation, Risk Management by David /
3 Comments

In a speech on last week Mary Miller, Treasury under secretary for domestic finance, made the case that the Dodd-Frank reform legislation has substantially ended the problem of too-big-to-fail financial institutions. Johnson and Parsons don’t agree, writing in the NYT:

Ms. Miller’s speech is completely unconvincing on the substance of the points that she is trying to make. Dodd-Frank alone will not end too big to fail.

It makes sense that senior Treasury officials should want to put Dodd-Frank into effect. But it is disconcerting when they are unable to confront the market and political realities of too-big-to-fail banks. Any such level of denial will not serve us well.

The detailed analysis is worth going through and, broadly, convincing. It does seem interestingly as if the argument is lining up as some politicians, most independent commentators and much of the voting public saying more needs to be done, with the FED and the big banks against. That isn’t a common side selection, and it will be interesting to see how it plays out.

Posted in: Regulation by David /
1 Comment

The FT has a timely article on the consequences of the EU’s ban on naked CDS:

Investors are buying protection on European banks on the basis that banks and sovereigns are so intimately linked that any increased risk of a sovereign default will increase the value of a bank CDS in a similar way to a sovereign CDS.

“The big downside of the ban is that it is likely to increase borrowing costs for financials,” said Michael Hampden-Turner, Citigroup credit strategist.

“It is hardly good for Spanish and Italian banks if the cost of borrowing is being squeezed up on the back of European regulation.”

Essentially then national champion banks are being used as proxies for the sovereign, with CDS buying (driven in part by CVA hedging) pushing out these banks’ credit spreads. The only way this loop will be broken will be if sovereigns either post collateral against their OTC derivatives (unlikely) or clear (somewhat more likely, but with its own problems).

Posted in: CDS and Negative Basis, Regulation by David /
3 Comments

This man really knows how to make a speech. The following is from one he gave in Basel (!):

An inherent problem with a risk-weighted capital standard is that the weights reflect past events, are static, and mostly ignore the market’s collective daily judgment about the relative risk of assets. It also introduces the element of political and special interests into the process, which affects the assignment of risk weights to the different asset classes. The result is often to artificially favor one group of assets over another, thereby redirecting investments and encouraging over-investment in the favored assets. The effect of this managed process is to increase leverage, raise the overall risk profile of these institutions, and increase the vulnerability of individual companies, the industry, and the economy… If the Basel risk-weight schemes are incorrect, which they often have been, this too could inhibit loan growth, as it encourages investments in other more favorably, but incorrectly, weighted assets. Basel systematically encourages investments in sectors pre-assigned lower weights — for example, mortgages, sovereign debt, and derivatives — and discourages loans to assets assigned higher weights — commercial and industrial loans. We may have inadvertently created a system that discourages the very loan growth we seek, and instead turned our financial system into one that rewards itself more than it supports economic activity.

Clearly there is some truth to this. I don’t buy Hoenig’s argument (via Admati and Hellwig) that the cost of moving to a high simple leverage ratio is small: it isn’t. But it may still be worth it.

Posted in: Regulation by David /
5 Comments

Go and read Lisa’s excellent post on Pat Hagan’s skills in titling emails and optimising capital.

Posted in: Regulation, Reputational Risk by David /
1 Comment

From Bloomberg:

The largest U.S. banks… would have to hold capital in excess of Basel III standards under a proposal being drafted by Senate Democrats and Republicans to curb the size of too-big-to-fail banks.

The current draft of the legislation would require U.S. regulators to replace Basel III requirements with a higher capital standard: 10 percent for all banks and an additional surcharge of 5 percent for institutions with more than $400 billion in assets. Senators Sherrod Brown, a Democrat from Ohio, and David Vitter, a Republican from Louisiana, have said they intend to introduce the bill this month.

I doubt that they can get this through Congress in this form, but you have to applaud the attempt.

Update. The full text of the bill is here. It’s even more interesting than the Bloomberg story indicates. The highlights are:

• 10% simple leverage ratio limit;
• ‘Continuously increasing’ capital requirements above $400B of total assets (although it doesn’t say how);
• Total assets include gross derivatives unless daily VM is exchanged;
• A ban on Basel III implementation in the US;
• Prohibitions on affiliate transactions and an anti-avoidance clause.

Posted in: Regulation by David /
5 Comments

From the Parliamentary Commission on Banking Standards report into the collapse of HBOS:

A huge amount of regulatory time and attention, in relation to HBOS as with other banks, was devoted to the Basel II model approval process… HBOS attached importance to obtaining the so-called ‘advanced status’, because it would potentially enable them to hold a lower level of regulatory capital.

The HBOS application was then granted in September 2007, subject to conditions that needed to be satisfied by 1 January 2008. Michael Foot (the FSA Managing Director for Deposit Takers and Markets 1998-2004) described Basel II as “immensely complex and immensely resource demanding” and “a complete waste of time”…

From 2004 until the latter part of 2007 the FSA was not so much the dog that did not bark as a dog barking up the wrong tree. The requirements of the Basel II framework not only weakened controls on capital adequacy by allowing banks to calculate their own risk-weightings, but they also distracted supervisors from concerns about liquidity and credit; they may also have contributed to the appalling supervisory neglect of asset quality.

Posted in: Regulation by David /
4 Comments

There has been a lot of negative comment about the Cyprus deal. That is understandable: you can reasonably argue that it will produce crippling austerity; that it is ridden with moral hazard; that it will create a bank run across most of Southern Europe. But what you can’t argue is that it was unexpected. After all, as Sony Kapoor points out, the standard template for bank resolution calls for bond holder and, if needed, uninsured depositor bail in together with liquidity assistance from the money printer. We got what was planned. If the plan isn’t a good one, there are bigger issues than Cyprus that we need to address.

Posted in: Economic Theory, Eurocrisis, Regulation by David /
Comments Off

There has been a blog-fight between Bloomberg, whose editorial suggested that large US banks enjoy an 80 bps funding subsidy from the tax payer, and Matt Levine, who came to, well, a lower number. Now, I don’t really have a dog in this fight, but I was amused to note that SIFMA, a trade association, quoting the IMF, came to a 20bps subsidy.

Let’s assume that the subsidy is indeed 20 bps, and moreover that that 20 applies just to non-deposit funding. We will take JPMorgan, as that seems to be the paradigmatic example. JP has roughly speaking $2.4T of assets, funded by $1.2T of deposits, $200B of shareholder’s funds, and $1T of debt (quite a bit of it short term). So suppose JP enjoys a 20bps subsidy on that $1T*. That comes to $2B. Two billion dollars. To put this number in context, JPM’s last dividend payment was roughly $1.1B (30 cents a share last quarter to 3.8B shares). So the annual state subsidy JP gets, using trade association numbers, covers 40% of what JP gives shareholders. Um. I don’t know about you, but if this is even vaguely plausible, then the US taxpayer could legitimately be quite peeved about it‡.

*Obviously the 20 is a blended number; it won’t apply equally to all maturities of debt, nor equally to secured vs. unsecured funding.

‡For an earlier discussion of the UK taxpayer, see here.

Posted in: Credit, Markets, Regulation by David /
5 Comments

I’m a little busy, so this will be short form:

• Jon Danielsson has a piece on VoxEU about the desirability of diversity in capital models. I don’t agree – I think we need fewer models used for capital purposes – but the argument is interesting.
• There’s a (sadly firewalled) opinion piece by De Larosière on centralbanking.com about the tradeoff between bank regulation and economic growth. Unsurprising, he comes down on the side of too much regulation (in places) and too little growth.
• LSE/LCH looks to be nearly done.
• Scott O’Malia is not happy about the CFTC approving CME’s trade repository.
• There is an effort to repeal the swaps pushout provision (section 716) of Dodd Frank. It is early days, but this may come to something.
• And finally… the corporate CVA exemption is apparently still in the near-final text of CRD IV. if you know what that somewhat opaque sentence means, then you will likely cheer: if you don’t, err, sorry, try here.

I will try to get to the RBS breakup news tomorrow.

Posted in: Clearing and Collateral, Regulation by David /
Comments Off

Matt Levine is sad:

Today is a dark day.

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

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

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

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

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

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

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

Posted in: Basel, CDS and Negative Basis, Credit, Regulation by David /
Comments Off

Those guys. Wow. Soooo cute.

Occupy the SEC has filed a lawsuit in the Eastern District of New York against six federal agencies, over those agencies’ delay in promulgating a Final Rulemaking in connection with the “Volcker Rule”.

Posted in: Legal Risk and Trade Documentation, Regulation by David /
4 Comments

The FT tells us

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

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

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

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

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

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

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

The analysis conducted so far suggests that:

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

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

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

Posted in: Basel, Mortgages, Regulation by David /
2 Comments

Good sense on regulatory change from Charles Whitehead:

This Article argues that a better approach to new financial risk regulation is to introduce it in stages… Regulators should be authorized to phase-in or forego additional regulation over time as it becomes clear, through experience, what the likely impact will be… [This] approach relies on real options to introduce new regulation. The use of real options in the transactional world is based on the insight that it can be valuable for managers to adjust their strategies based on new information they acquire over time rather than commit to a rigid approach initially.

The choice of regulation, of course, is not irreversible. A poor decision, or a new rule with unanticipated consequences, can be reversed at a later stage—but, potentially, at significant expense. By staging implementation, regulators can develop additional information on the effect of new rules on market conduct, potentially at lower cost than a subsequent change in regulation.

Posted in: Regulation by David /
Comments Off

Sweden has made a countercyclical move. Bloomberg tells us:

Sweden’s financial regulator says it’s ready to tighten restrictions on mortgage lending to stop banks feeding household debt loads after a cap imposed during the crisis failed to stem credit growth… The [Swedish] FSA is ready to enforce a cap limiting home loans relative to property values to less than the 85 percent allowed today, [director general of the FSA] Andersson said. Banks may also be told to raise risk weights on mortgage assets higher than the regulator’s most recent proposal, he said.

Coming as it does on top of Switzerland’s use of a countercyclical buffer, and noises from Australia on measures to deflate the housing bubble there, this is interesting. We are starting to see countercyclical regulatory policy in action.

Posted in: Mortgages, Regulation by David /
Comments Off

Previously I have suggested a regulatory capital multiplier that is quadratic in balance sheet size over some threshold as an incentive for too big to fail banks to split themselves up. But now Richard Stallman has something I like even more: tax rates that increase with company size.

We tax a company’s gross income, with a tax rate that increases as the company gets bigger. Companies would be able to reduce their tax rates by splitting themselves up.

With this incentive, over time many companies will likely get smaller. They could subdivide in ways they consider most efficient – rather than as decided by a court. We can adjust the strength of the incentive by adjusting the tax rates. If too few companies split, we can turn up the heat.

Big companies can afford clever lawyers. They may try, for example, to pretend to split up into several companies that effectively work together as one. So the new tax law must recognize this and treat such entities as one company that pays the rate for its combined size. As for how to recognize and define such combinations, we can probably borrow solutions from antitrust law.

That is just beautiful. The only delicate part is setting the thresholds. You’d probably have to do that on an industry-by-industry basis, using HH indices to monitor concentration and decide when to increase the size penalty.

Posted in: Regulation, Taxation by David /
Comments Off

I want to distinguish two issues, as a prelude to another post on central capital calculations.

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

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

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

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

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

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

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

*Which are enormous.

Posted in: Basel, Regulation by David /
6 Comments

Izabella Kaminska, good though she usually is, is mistaken. She says on FT Alphaville:

Bank resolution is fundamentally about transferring bank responsibility (and risk) away from the public sector and back to the private sector. It’s about making the banks responsible for themselves again by weaning them off state-aid.

Even though government loans have on the surface been repaid, the central bank put and the understanding that these institutions are now too big to fail, implicitly continues to provide an equity backstop. The equity risk has thus not yet really been transferred to the private sector at all.

(Emphasis from the original.) In resolution, bank equity is usually written off. That hurts private sector investors. Resolution regimes even allow debt to be written down. Again, this is a risk private sector investors in banks bear. So Izzy’s claim in the final sentence does not hold water.

Next, QE and the lack of a bid for bank equity:

while QE has been successful at encouraging the market to take risk in some quarters of the market, it’s failed dismally at persuading investors that the bank model is ever going to be a good bet — even in a less risky environment.

Yes, because bank investors are terrified that supervisors might listen to someone like Admati (an academic who inspired Izzy’s article) and demand that banks issue a lot more equity. If they do, current investors are diluted. The risk of that, combined with bank opacity, means that there are few buyers for bank equity. Most large banks are perfectly profitable, so Izzy’s claim that

banks are borrowing short and lending or investing long … in a way that continuously destroys capital.

Is simply wrong – they are having ROE issues, but that’s different. From errors of fact, it is hardly a surprise that errors of diagnosis result. For instance further down the post we find

the only solution lies either in fully equitising banking or turning to a borrowing long, lending short alternative

Banking isn’t broken, and there is still plenty of money (and bearable amounts of risk) to be made in taking deposits and making loans. Banks borrow short and invest long because that is what clients want them to do. And yes, because the curve usually points up and so you can make money doing it. Upward pointing curves will come back in due course. What’s broken is investor’s trust in bank regulation and bank disclosures – and the solution to that isn’t using a theorem that doesn’t hold in practice (Miller Modigliani) to justify a radical, unproven change in regulation like requiring that banks be 100% equity funded at a time when the monetary transmission mechanism is broken. I would even suggest that there is far more systemic risk in taking Admati’s ideas seriously than there is in current arrangements.

Posted in: Economic Theory, Regulation by David /
Comments Off

As many have noted (see here for Alphaville and here for Dealbreaker), the BIS study on market risk weights is out. To no one’s surprise, the results show that different banks calculate radically different capital requirements for the same portfolio. The report is full of embarrassing graphs like this. (It shows the variation of the three components of models-based trading book capital, VAR, stress VAR and IRC, for seven test portfolios (18-24).)

As Dealbreaker acidly puts it, banks rarely differ from each other by more than a factor of ten. It’s no wonder, then, that investors are losing trust in capital ratios. The answer is clear. Centralize and standardise capital calculation. Throw all those internal models away, and use one common, regulator developed approach. Now that a lot of progress has been made on trade reporting, the data infrastructure exists to do this — or least it wouldn’t be too hard to extend what does exist to do it. Developing the models would be a huge undertaking, but compared to having each large bank do it individually, a central infrastructure would be cheaper and more reliable, and anyway you could pick the best of individual banks’ methodologies. You could even spin out the var teams from four or five leading banks into the new central body — just don’t pick the bank whose IRC is less than 10% of the average answer…

Posted in: Regulation by David /
8 Comments

The Tobin project’s new book on Preventing Regulatory Capture can be found here. The title is a little ambitious – there is more analysis of the phenomenon of regulatory capture than discussion of its prevention in the book – but many of the chapters are worth reading. I recommend in particular William Novak’s History of the idea of regulatory capture. McCarty is interesting too, not so much for his model of regulation in the presence of complexity and partial information (which I don’t really buy) but for the proposal that a model is needed to understand situations like this. Sadly Kwak’s chapter on financial regulatory capture is one of the weaker ones, although I do like his ideas on negotiated rulemaking, tri-partism and the use of devil’s advocates. I’ll leave you with Novak’s call to arms:

…the problems of faction, special interest, special privilege, and private coercion are not going away anytime soon in this still open and democratic society. And it is but a chimera to presume that a simple dismantling of an earlier era’s checks and balances and regulatory institutions will somehow automatically and spontaneously vitiate the age-old problems of inequality, privilege, and private (as well as public) coercion. The problems of regulation and capture will not be solved by fleeing to some kind of imaginary laissez-faire past.

Posted in: Regulation by David /
Comments Off

My paper Maintaining Confidence – Understanding and preventing a major financial institution failure mode has been published as an LSE Financial Markets Group special paper, and is available here. From the abstract:

This paper proposes the solvency/liquidity spiral as an failure mode affecting large financial institutions in the recent crisis. The essential features of this mode are that a combination of funding liquidity risk and investor doubts over the solvency of an institution can lead to its failure. We analyse the failures of Lehman Brothers and RBS in detail, and find considerable support for the spiral model of distress.

Our model suggests that a key determinant of the financial stability of many large banks is the confidence of the funding markets. This has consequences for the design of financial regulation, suggesting that capital requirements, liquidity rules, and disclosure should be explicitly constructed so as not just to mitigate solvency risk and liquidity risk, but also to be seen to do so even in stressed conditions.

Posted in: Liquidity and liquidity risk, Regulation by David /
3 Comments

Before Christmas, I had a fascinating exchange of comments with long-time and insightful reader Quality Mullet. It began with my observation

It seems to me that the great debate we are not having is what we want the system to look like. If supervisors said `here is what we want, broadly’, then everyone could critique rules on that basis. As it is, supervisors have (often disparate) ideas of what they are trying to achieve which are not publicly articulated. The rules are a result of compromises between supervisors and so are intended to push towards the desired objectives, but often they don’t because of unintended compromises, conflicts between objectives, or because they are either too strong or too weak. The whole paradigm of `do what we are thinking of based on these rules’ is flawed – here’s what we are thinking of, help us get there would be better, but it would require both honesty about objectives and the ability to articulate what they are.

Put tersely, I was suggesting that rather than write rules to achieve a desired end state, supervisors should first articulate what their desired end state is, and then write the rules. That way, we could all judge the rules by their efficiency at achieving the goal, rather than trying to figure out what the goal was (and not being sure we had got it right).

In a sense, then, I am suggesting that the whole dialogue is at the wrong level. We discuss rules, when these are mean simulacra of their desired effects on the financial system. We are talking about the wrong thing when we argue about, say, the new Basel ABS rules improve financial stability or not. We should first say, for instance, that we want banks to hold fewer ABS (with all that that implies). Once that is clear, we can debate how to do that effectively.

QM commented in reply

… what’s not much talked about is how the regulatory framework and system structure you want is actually a very very important social contract. In the UK it is presumed the social contract has to be tilted away from public support but the debate is lop-sided, ignoring what it means on a day to day basis to end users. Vickers to his credit set out some of the tradeoff of losing a contingent liability but gaining a costlier … service. No one has taken his analysis much further in the public policy / social contract space.

This for me is absolutely correct. There is a social contract, and regulatory goals articulate it. By saying, for instance, that we do not want capital markets trading to ever be able to take a retail bank down, we are expressing part of the contract under which society has decided to let banks operate. We should make this contract explicit in order first for it to be agreed and second to better judge what the rules should say.

This then leads to my last observation: because the contract is implicit, it is fuzzy. Supervisors have not been forced to articulate their vision of it, nor has that vision been critiqued. By keeping dialogue at the level of the rules rather than the aims, we allow an unhelpful ambiguity to persist. If we don’t know what the official sector’s aims are, how can we judge their success or failure?

Posted in: Regulation by David /
11 Comments

If you weren’t, and you are a bank, times are about to get tougher. From a Shearman & Sterling memo on the FED’s latest announcement on the regulation of foreign banks in the US:

[It is proposed that] foreign banks under Federal Reserve supervision be subject to requirements that (1) they establish a US intermediate holding company for all US subsidiaries, (2) the holding company comply with US capital adequacy requirements and liquidity constraints, and (3) US branches and agencies comply with unspecified liquidity constraints and limits on cross-border funding and derivatives activities.

I suspect the hard part about this will not just be complying, but demonstrating compliance. Foreign banks historically have not had to calculate the full panoply of US capital ratios, so their systems will have a hard time coming up with the numbers. The trade is clearly long consultants, short foreign banks.

Posted in: Regulation by David /
Comments Off

From the FT:

US banks are making a last-minute push to ease new global liquidity requirements, arguing that they would need to come up with an additional $800bn in easy-to-sell assets under the proposed standards.

While ISDA says that the impact of requiring initial margin for bilateral transactions with a $50M threshold and assuming everyone uses an internal model is $800B.

Them’s big numbers, yep.

Posted in: Clearing and Collateral, Regulation by David /
4 Comments

The press release for the most recent UK financial policy committee is interesting:

In today’s Report we draw attention to three reasons that lead us to think that UK banks’ capital ratios – and hence the buffers available to absorb unexpected losses – are currently overstated. First, expected future credit losses may be understated; second, costs arising from past failures of conduct may not be fully recognised; and third, the risk weights used by banks in calculating their capital ratios may be too optimistic… The FPC therefore recommends that the FSA takes action to ensure that the capital of UK banks and building societies reflects a proper valuation of their assets, a realistic assessment of future conduct costs, and prudent calculation of risk weights. Where such action reveals that capital buffers need to be strengthened to absorb losses and sustain credit availability in the event of stress, the FSA should ensure that firms either raise capital or take steps to restructure their business and balance sheets in ways that do not hinder lending to the real economy.

(Emphasis mine.)

Ooops.

Update. You can find more on this from Matt Levine here. The new financial stability review is here: capital junkies will want to see in particular charts 3.18, 3.19 and 3.20.

Posted in: Regulation by David /
3 Comments

Don’t worry, I’m talking to myself about slightly risque puns based on FICC. You see, Citi research has an interesting view of the state of FICC:

The result for subscale franchises is withdrawal. Here’s their eloquent illustration of UBS’s current capital usage and their plan:

Posted in: Regulation by David /
Comments Off

I’m not sure I entirely agree with Golem XIV, but I have to say that the guy has a nice turn of phrase. Consider this:

Risk is the pollution created by the process of making money.

He also picks up on something from Basel that I had missed, a note from the March quarterly on European bank funding and deleveraging. That points out just how few assets are being sold by banks despite capital ratio pressure:

The plans banks submitted to regulators in January 2012 suggest that the shedding of bank assets will play a small part in reaching the target ratio… The EBA’s first assessment shows that banks intend to cover 96% of their original shortfalls by direct capital measures

Posted in: Regulation by David /
1 Comment

Bloomberg has an interesting story on the Danish FSA’s pursuit of mis-stated financials at banks:

Denmark’s financial regulator is warning the country’s banks that an understatement of lending risks won’t be tolerated as it embarks on a hunt to catch what it’s dubbed “backdoor” capital dilution.

The Financial Supervisory Authority will review internal rating models that determine how much capital a lender sets aside to ensure banks don’t find a way around stricter standards. While banks may fulfill capital requirements on paper, recent failures suggest risk weights don’t always reflect reality, leaving buffers too small to absorb losses… When Denmark’s housing bubble burst more than four years ago, it revealed widespread capital shortfalls that have since led to the demise of more than a dozen regional lenders. Toender Bank A/S, the most recent insolvency, followed a reported three- fold increase in profit in the first half and a solvency ratio – - a measure of financial strength — of 17.3 percent at the end of June. Yet an inspection last month by the FSA revealed bad loans almost 10 times as big as those reported by the bank, wiping out its equity.

Bloomberg loses a few marks here for not being precise: the capital requirements are fine, but the capital available to meet them is bigger than it should be because the bank has not taken enough provisions and thus has over-stated its earnings. What is interesting is that when the Danish FSA tightened their standards on impairments, impairment charges doubled at one large (and well-regarded) bank, Nordea. Presumably the impact elsewhere was similar. This kind of solid, boring policing of lending is very important, so kudos to the Danish FSA for doing it. One does wonder what Toender’s auditors were doing though…

Posted in: Accounting, Credit, Regulation by David /
3 Comments