Category / Regulation

The distraction of Basel II April 5, 2013 at 4:38 pm

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.

Reacting to Cyprus March 25, 2013 at 4:55 pm

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.

Doing the subsidy maths March 14, 2013 at 12:35 am

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.

Quick links March 7, 2013 at 11:36 pm

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.

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

Matt Levine is sad:

Today is a dark day.

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

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

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

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

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

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

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

Loving occupy the SEC February 28, 2013 at 10:26 pm

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”.

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

The FT tells us

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

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

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

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

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

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

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

The analysis conducted so far suggests that:

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

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

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

Take it slowly February 21, 2013 at 6:43 am

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.

Deflating a Swedish bubble February 20, 2013 at 12:11 pm

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.

Fixing too big to fail February 5, 2013 at 6:31 am

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.

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

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

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

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

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

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

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

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

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

*Which are enormous.

Misconceptions about bank equity February 2, 2013 at 6:51 am

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.

Is it time to centralise capital calculation? February 1, 2013 at 3:45 pm

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).)

Hypothetical portfolio exercise

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…

Preventing Regulatory Capture January 25, 2013 at 9:22 pm

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.

‘Maintaining Confidence’ paper is up January 8, 2013 at 6:11 pm

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.

Being open about supervisory aims January 4, 2013 at 7:20 am

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?

Born in the USA December 19, 2012 at 8:38 am

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.

$800B, twice December 17, 2012 at 5:15 pm

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.

Prudence comes to risk weights near you November 30, 2012 at 7:23 am

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.

No really you mustn’t November 28, 2012 at 6:59 am

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:

State of FICC

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

State of UBS