A small town in Switzerland, part 3

Glorious, glorious, glorious is the day: yet more Basel. Here's a key passage from BCBS158:

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

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

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

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

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

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

A small town in Switzerland, part 2

The review of the changes to Basel 2 now moves to the credit risk rules. There isn't much that is new here either: some tweaking of the credit conversion factors for liqudity facilities, and a new, seemingly penal treatment of CDO squared positions (which the committee in keeping with its mission to call everything by a different name to everyone else, call resecuritisations). Here are the risk weights:
Two things spring to mind at once. The classifying criteria is rating. That's right - the ratings agencies, who did such a sterling job at rating ABS that they are facing multiple lawsuits and much approbrium, are still at the heart of regulatory capital. And given that, 20% is hardly penal for a AAA CDO squared tranche. Roll on re REMIC.

A small town in Switzerland, part 1

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

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

Counter-cyclical capital

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

Incremental risk in the trading book 1

As part of a series on the new Basel Committee Trading Book proposals, notice first that the text contains quite a sophisticated notion of time horizon:

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

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

Basel committee still clueless chumps

They say... CDOs of ABS (so-called "resecuritisations") are more highly correlated with systematic risk than are traditional securitisations. Resecuritisations, therefore, warrant a higher capital charge. Fine so far. But then look what they do:(The new capital charges are in the grey hatched columns.) So the capital charge for a senior charge of a AAA-rated CDO-squared will be 1.6% of notional (20% x 8%). Anyone who thinks this is adequate was clearly taught in the Jimmy Cayne school of Structured Finance.

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

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

Unrealised P/L and Tier 4 capital

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

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

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

Basel 3

I have sniped, perhaps too much, at Basel 2. So it only seems reasonable to outline some alternative proposals, particularly as Lord Turner is apparently open to significant change. Here goes.

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

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

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

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

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

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

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

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

Two sensible comments

The first from Clusterstock:

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

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

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

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

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

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

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

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

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

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

Basel 2: Installing smoke alarms while Rome burns

I have detected a slightly more sarcastic tone than usual in my recent posts and I had resolved to be nicer. But then something like this comes along:

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

The details are here and here.

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

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

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

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

Eat (a little of) what you kill

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

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

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

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

The FED proposes the standardised approaches in Basel 2

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

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

Right target, wrong ammo

The FT reports:

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

Up to a point your honour. Certainly there is a well-documented problem with the imprudence of VAR models, especially (but not only) ones which do not capture all the relevant risk factors. But the credit risk rules are not a shining example of prudence either, especially for low PD portfolios.
One need only compare JPMorgan's capital allocation for market risk -- $9.5B at Y/E 2007 -- with its VAR -- $107M -- to see the problem with trading book capital based on VAR alone. But the solution is not to dump on structured products alone: it is to revamp the entire market risk regime.

Why the long ABS?

Gillian Tett comments on the large supersenior ABS holdings at Merrill and UBS in the FT backed by mortgages on properties like the fine abode above:

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

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

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

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

Yesterday's Basel press release

On Wednesday the Basel committee announced some changes to the Basel II framework. The press release is fairly short on detail, but it does give some insight into the forthcoming detailed proposals. Let's take a look.

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

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

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

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

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

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

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

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

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

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

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

What about capital for liqudity risk?

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

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


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

The IMF Financial Stability Review: Chapter 2

Perhaps the most important part of Chapter 2 is a (mitigated) vote of confidence from the IMF in structure finance at the beginning:

Structured finance can be beneficial by allowing risks to be diversified

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

• First a remark from the IMF about ratings: In particular, when reliable price quotations were unavailable, the price of structured credit products often was inferred from prices and credit spreads of similarly rated comparable products for which quotations were available. For example, the price of AAA ABX subindices could be used to estimate the values of AAA-rated tranches of mortgage-backed securities, the price of BBB subindices could be used to value BBB-rated MBS tranches. [...] In this way, credit ratings came to play a key mapping role in the valuation of customized or illiquid structured credit products, a mapping that many investors now find unreliable. This is important and has not received that much comment thus far. Many firms are currently marking a lot of ABS, some of it rather different from typical US subprime, as a spread to the ABX. They are doing this because they can't think of anything better to do. But of course this only works if AAA ABX is comparable with AAA something else. So not only were ratings important for some purchasing decisions, they continue to be important for marking inventory. Which is scary.
  
• Credit rating agencies insist that ratings measure only default risk, and not the likelihood or intensity of downgrades or mark-to-market losses, many investors were seemingly unaware of these warnings and disclaimers. True, but really can we have a small does of caveat emptor please?
  
• Next a very sensible observation on fair value: Accounting frameworks require professional judgment in determining the mechanisms for fair value, including the use of unobservable inputs in cases of the absence of an active market for an instrument.
  Such judgment allows the possibility of different outcomes for similar situations, which in times of market uncertainty may compound the risk of illiquidity. As instruments turn illiquid moreover, they move from level 1 or level 2 of the FAS 157 hierarchy to level 3. The IMF notes that some people have drawn the wrong conclusion from this:investors seem to have a perception contrary to what the standard setters intended because a firm risks a negative market reaction with a reclassification of assets from level two to three, as events during the turmoil indicated.
  
• Reasonably enough, the IMF is concerned about SPV assets coming back on balance sheet at the worst possible moment, with no hint prior to that of the exposure. They opine:investors would benefit from more comprehensive regulatory requirements for disclosures about the scope and scale of exposures to OBSEs. [...] Increased disclosure achieved through consolidation or some form of parallel disclosures of an entity’s unconsolidated and consolidated positions also means these entities have a direct impact on the institution’s regulatory capital requirements, funding sources, and liquidity. (OBSE is IMF speak for SPV.) If this suggestion is taken seriously it will mean a huge change to IFRS. My sense is that the regulators will go further and faster than the accountants on this (not least because the accountants are saying “completing a final standard by mid-2011 will be extremely difficult, perhaps impossible”). Certainly caps on the regulatory benefit for securitisation are under active consideration.
  
• Will banks voluntarily take more of the OBSE’s assets onto the balance sheet to provide greater assurance to investors as to the vehicle’s quality? Only if that is the only way to get the securitisation market restarted and/or if regulators make them. Or should banks be required to retain a stake in the performance of these assets, thus having the incentive to conduct better due diligence? Yes.
  
• In general, variations in the regulatory treatment of securitization among different types of financial institutions may provide an opportunity for regulatory arbitrage across financial sectors. Some securitization exposures are evaluated for regulatory purposes differently for insurance companies than for banks. Finally in between congratulating themselves on the level playing field between banks someone in the supervisory community has noticed that the playing field between banks and non-banks is far from level. Basel 2 is flawed in many ways but it looks pretty good compared with insurance capital requirements for the monolines.
  
• Finally it is worth noting that the banks did not play the SIV and conduit game cynically: many of them seemed to have believed that risk really had been transferred. Or as the IMF puts it the perimeter of risk for financial institutions—that is, the risk assessment of all of an institution’s activities, including its related entities—did not adequately take into account the size and opacity of institutions’ exposures to SIVs, commercial paper conduits, and their related funding support. Given the size of the SIV and conduit activity, this failure of risk assessment is a big deal for the banking system.
  

The IMF Financial Stability Review: Chapter 1

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

My tuppence ha'penny:

• The headline credit crunch loss predicted by the IMF of $1T has received a lot of press, not least because it is rather larger than the $460B some other commentators have been focussed on. Firstly no one really has any idea at this stage, and secondly it is half the estimated value destruction in the 1994 bond market crisis; so while it is a large number, we should not be too freaked by it.
  
• There is a lot of good information in the report. For instance this table showing the dependence of a number of European banks on wholesale funding, may be of use in selecting your next short. Just remember it is hard to make money shorting the Republic of France or its wholly controlled subsidiaries.
  
  
• According to the IMF there has been a massive rise in leverage of global banks. The report has this picture showing the growth of Bank assets and Basel 1 risk weighted assets, which I don't understand.
  
  Here's my problem. Consider the Basel 1 risk weights:
  
  

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

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

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

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

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

  I think that is wildly optimistic. Everything we are seeing from the retail and commercial mortgage markets, for instance, suggests that credit growth will be negative for the next half year at least.
  
• The IMF administers a richly deserved kicking to the monolines and their system of regulation:

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

  
  

Risk sensitivity bites

We knew in the abstract this happens, but seeing it in the particular is chastening. From FT alphaville, discussing research from Credit Suisse:

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

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

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

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

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

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

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

Anti-cyclical capital ratios anyone?

Inadequate broker/dealers?

Bloomberg has an interesting article on Goldman which again highlights the preferential capital position of the US broker/dealers vs. the banks.

Less than 48 hours after a government-backed deal rescued Bear Stearns Cos. from bankruptcy, David Viniar, Goldman Sachs Group Inc.'s chief financial officer, was asked if the crisis would have ``permanent implications'' for Wall Street's appetite for leverage. His answer: ``No, I don't.''

Tell that to his rivals, most of whom are selling assets, raising additional capital and hoarding cash as they grapple with unprecedented losses. The financial industry has booked more than $230 billion of writedowns and losses, as debt securities, mostly held with borrowed money, plummeted in value.

Goldman alone is holding course, refusing to trim its leverage, a measure of how reliant a firm is on debt. The adjusted leverage ratio of assets to equity jumped to 18.6 at the end of February, from 17.5 at the end of November. ``We have no need as we sit here right now to shrink our balance sheet,'' Viniar told analysts on the March 18 conference call.

Now we don't know what the composition of Goldman's BS is. But it is safe to suggest most of it will be assets that are 100% weighted under Basel 1. On that crude basis, Goldman's capital ratio is roughly 5.4% (= 1/18.6) vs. a minimum of 8% for a bank. Surely this at least suggests the possibility of smelling a rat?

Update. Another Bloomberg article puts a more diplomatic version of the same question:

The U.S. has allowed a number of institutions such as Bear to emerge that really are in the business of doing what banks do but haven't been folded into the banking system in a way that affords them the same kind of protection from runs that banks have.

Capital: breaking the cycle

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

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

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

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

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

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

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

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

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

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

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

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

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