IRB PD variation, US style December 8, 2013 at 8:18 pm
From the FED, what might be interpreted as the case for the prosecution in the case of Bank Investors vs. the IRB:
Category / Regulation
From the FED, what might be interpreted as the case for the prosecution in the case of Bank Investors vs. the IRB:
To date, over-the-counter derivatives reform is the primary example of a post-crisis effort at market-wide regulation. Given that the 2007–2008 financial crisis was driven more by disruptions in the SFT markets than by disruptions in the over-the-counter derivative markets, comparable attention to SFT markets is surely needed.
So, um, you admit that “the 2007–2008 financial crisis was driven more by disruptions in the SFT markets than by disruptions in the over-the-counter derivative markets” but you regulated the latter first, not the former? Shurley shome mishtake?
The second consultative document on the fundamental review of the trading book is out: you can read it here. A few highlights:
It’s consultative, and you have until 31st January 2014 to get your comments in. Happy Christmas.
Let me be clear: if it was my choice, I’d pick Janet Yellen as FED chief. But that said, I wouldn’t rule Summers out on the basis of his prior statements on financial regulation. Reading this, for instance, I don’t see the outrage. The key section seems rather well balanced to me:
Let me be clear, it is the private sector, not the public sector, that is in the best position to provide effective supervision. Market discipline is the first line of defense in maintaining the integrity of our financial system.
The public sector, for its part, has three fundamental roles.
- First, it needs to create an environment in which market discipline can work effectively. Counterparties and creditors have more knowledge of their counterparts, more skill in evaluating risk and greater incentives than any public regulator will ever have. The best approach to regulation is therefore to maximize the quality of counterparty discipline and to ensure that public activities do not crowd out the supervision provided by counterparties, creditors and investors.
- Second the public sector must promote the maximum degree of transparency, because transparency is the necessary corollary to counterparty discipline. The government cannot impose counterparty discipline, but it can help to enhance the effectiveness of market discipline by creating an environment of greater transparency and disclosure. Indeed, the long history of transparency in our financial markets has been a source of great strength, and a leading factor in maintaining the integrity of U.S. markets.
- Third, the public sector has a duty to maintain the competitiveness of the system as a whole. Just as there is a sharp distinction between support for the free enterprise system and support for individual enterprises, so also the task of public policy must be to ensure the stability and integrity of the market system rather than to seek to ensure the survival of individual firms or investors. Regulation must never hold out the prospect that it can eliminate risk or that it can prevent any individual institution from failing. Any regime that had that effect would be perverse and counterproductive and undermine market discipline.
For me, that passage has aged rather better than many similar vintage remarks on the same topic. Perhaps if we had actually done some of those things post LTCM – notably improved disclosure, improved private sector risk management, and ensured the integrity of the system – we wouldn’t have had the same intensity of crisis. There are many reasons to prefer Yellen to Summers, including the Shleifer affair and his investment management record, but Larry’s views on financial regulation aren’t amongst them.
Philip McBride Johnson’s article in FOW has been causing a few heckles to rise. Essentially he claims that the swaps community has only themselves to blame for the higher margin period of risk on OTC derivatives vs. swaps because they claimed that OTC derivatives were different. Legislators, Johnson says, listened, and put swaps in a different category from futures.
What’s interesting about this is that there is a core to his argument that’s correct. Swaps and futures do have some common risk features. The regulatory environment should depend on their characteristics, not their legal form. Some types of swap are very liquid, for instance, and a 5 day margin period of risk might well be conservative for them. Some futures are less liquid, and a one day margin period of risk, as in the US, for them might be generous. But each side has defended its turf: the some in the futures community have been vociferous in their claims for the liquidity of futures, for instance, claims which are not true of all futures, all of the time. To state the obvious, the US regulatory framework here is not exclusively the result of lobbying from the OTC derivatives community.
For me, the clear lesson from this is that it is dangerous to base regulation on form rather than substance. If you can make two different types of transaction do the same thing, roughly, but they have different regulatory environments, then you encourage trading in the less burdened type. Why tilt the playing field? There may be good reasons, of course, but if it is just an accident of typology, that’s unfortunate.
Matt Levine says, apropos the Goldman earnings call, that
someone at Reuters counted the number of times he [Harvey Schwartz, Goldman CFO] was asked to quantify Goldman’s leverage ratio (eight) and the number of times he did (zero).
Matt’s then amusingly unkind about Goldman’s explanatory note. He’s kinda right, it does bluster. So what’s the real reason for the silence? Well, I don’t know, but perhaps GS has a trick (or more likely at least 7 tricks) for getting less leveraged. You know, repo conduits, new netting schemes, securitisations with retained thick equity, that kind of stuff. But Harvey doesn’t know which of them will work yet, and maybe his people have to eat a few lunches in Norwalk to find out. So he’s keeping stumm until he finds out what works and how much good it will do. That will tell him if he needs to, you know, retain earnings or something distasteful like that.
The draft bill proposes the repeal of the Gramm-Leach-Bliley Act, and, after a transition period, that
An insured depository institution may not—
(i) be or become an affiliate of any insurance company, securities entity, or swaps entity;
(ii) be in common ownership or control with any insurance company, securities entity, or swaps entity; or
(iii) engage in any activity that would cause the insured depository institution to qualify as an insurance company, securities entity, or swaps entity.
I doubt that it will pass in this form, but as mood music it is interesting.
Citi Research point out, in an excellent short note US Leverage, European Read-through that while the US leverage ratio is set higher, at 5%, than Basel it is both smaller scope (bank holding companies with more than US$700bn in consolidated total assets or US$10trn in assets under custody) and on a different basis (full derivatives netting, inc. collateral vs. exposure netting). Moreover both the US and Basel 3 definitions are based on Tier 1 capital, not CET1.
Note first that both Barclays’ and Deutsche’s US operations fall below the size threshold, and that covered US institutions will have until 2018 to comply. All in all, it could have been a lot harsher. Still, it makes safer, balance sheet intensive businesses (repo?) look pretty unattractive – unless you can get it off B/S. Repo conduits anyone?
… the CVA book of course. From the new FED rules:
Therefore, the agencies clarify that non-credit risk hedges (market risk hedges or exposure hedges) of CVA generally are not covered positions under the market risk rule, but rather are assigned risk-weighted asset amounts under subparts D and E of the final rule [the standardised and IRB banking book rules].
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.
…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.)
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.
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.
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).
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.
Go and read Lisa’s excellent post on Pat Hagan’s skills in titling emails and optimising capital.
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:
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.
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.