Category: Regulation

The Bank for International Settlements issued a press release on January 11 (sorry I’m so late reporting!) titled Group of Central Bank Governors and Heads of Supervision reinforces Basel Committee reform package setting a road map for the next elements of bank regulatory reform:

Provisioning: It is essential that accounting standards setters and supervisors develop a truly robust provisioning approach based on expected losses (EL)….The Basel Committee should translate these principles into a practical proposal by its March 2010 meeting for subsequent consideration by both supervisors and accounting standards setters.

Introducing a framework of countercyclical capital buffers: Such a framework could contain two key elements that are complementary. First, it is intended to promote the build-up of appropriate buffers at individual banks and the banking sector that can be used in periods of stress. This would be achieved through a combination of capital conservation measures, including actions to limit excessive dividend payments, share buybacks and compensation. Second, it would achieve the broader macroprudential goal of protecting the banking sector from periods of excess credit growth through a countercyclical capital buffer linked to one or more credit variables.

Addressing the risk of systemic banking institutions: Supervisors are working to develop proposals to address the risk of systemically important banks (SIBs). To this end, the Basel Committee has established a Macroprudential Group. The Committee should develop a menu of approaches using continuous measures of systemic importance to address the risk for the financial system and the broader economy. This includes evaluating the pros and cons of a capital and liquidity surcharge and other supervisory tools as additional possible policy options such as resolution mechanisms and structural adjustments. This forms a key input to the Financial Stability Board’s initiatives to address the “too-big-to-fail” problem.

Contingent capital: The Basel Committee is reviewing the role that contingent capital and convertible capital instruments could play in the regulatory capital framework. This includes possible entry criteria for such instruments in Tier 1 and/or Tier 2 to ensure loss absorbency and the role of contingent and convertible capital more generally both within the regulatory capital minimum and as buffers.

Liquidity….

Central Bank Governors and Heads of Supervision will review concrete proposals on each of these topics later this year.
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The fully calibrated set of standards will be developed by the end of 2010 to be phased in as financial conditions improve and the economic recovery is assured with the aim of implementation by the end of 2012. This includes appropriate phase-in measures and grandfathering arrangements for a sufficiently long period to ensure a smooth transition to the new standards.

The practical effects of not paying your best producers top rates because other parts of the bank are losing money are even now being illustrated:

Bank of America, Merrill Lynch’s owner, raised London managing directors’ base pay to about 230,000 pounds, from 150,000 pounds in 2009, said the people, who declined to be identified because the terms are private.

“Some of these firms were hemorrhaging talent, and those gaps are being filled in a hurry,” said Simon Hayes, London- based head of financial services at Odgers Berndtson, a 45-year- old recruitment firm. “The likes of Merrill and UBS in London and elsewhere have been hiring very aggressively to deal with the losses of the previous 18 months.”

Both banks are no longer taxpayer owned, leaving them free to set pay themselves.
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“In the world of investment banking, it’s a simple case of who pays wins,” said John Purcell, managing director of London- based executive search firm Purcell & Co. “Institutions that are fairly directly under political control are facing significant difficulties retaining staff.”

I am very pleased to see that BIS will officially be “evaluating the pros and cons of a capital and liquidity surcharge”. I have long advocated the imposition of surcharges on capital for size (although I feel this should be a surcharge on Risk Weighted Assets), rather than absolute caps or special regulatory regimes. This will allow the major banks to make decisions regarding asset growth to be made in a familiar business-like manner.

And finally, I’m very pleased to see contingent capital front-and-centre, although some indication of the committee’s thinking regarding triggers and conversion prices would have been very greatly appreciated. I can only suppose that this is a bone of contention.

In a prior post I discussed IFRS and the Assets-to-Capital Multiple with respect to banks and their mortgage securitization habits, but I’ve just realized there’s another nuance lying in ambush behind the thickets of regulation.

The OSFI Draft Advisory on Conversion to International Financial Reporting Standards (IFRSs) by Federally Regulated Entities (FREs) states:

With respect to life insurance entities, current CGAAP specifically requires that segregated funds should be accounted for separately (off balance sheet). However, IFRSs do not specifically address accounting for segregated funds. As a result, most segregated funds are expected to require consolidation treatment because of the “control” tests in IAS 27 and SIC 12. Most life insurers are, therefore, expected to report their segregated fund assets and liabilities on balance sheet through a one-line reporting format rather than commingled with other asset and liability categories.
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OSFI is not issuing any additional accounting guidance or clarification in this area at this time.

OSFI will consider the accounting treatment of segregated funds if it becomes apparent that life insurers intend to commingle assets and liabilities, rather than use the expected one-line reporting format.
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With respect to segregated funds, risk based capital requirements already exist and OSFI requires that the current treatment continue. Therefore, although segregated funds will appear on the balance sheet, they would not attract asset specific capital charges outside of the existing Segregated Fund Risk charge.

This is interesting in light of recent OSFI speeches by Julia Dickson:

As OSFI regulates non-operating insurers acting as holding companies, we are considering updating our current regulatory guidance for these entities to promote a more integrated and consistent approach to determining regulatory capital requirements. For example, OSFI’s MCCSR tests could be used to evaluate the group’s consolidated risk-based capital – and a test similar to the asset-to-capital multiple (ACM) test could be used to evaluate leverage.

… and her speech-tester, Mark White:

For example, OSFI’s Minimum Continuing Capital and Surplus Requirements (MCCSR) tests could be used to evaluate a financial group’s consolidated risk based capital – and an ACM like-test could be used to evaluate leverage.

These speeches were reported on PrefBlog in the posts OSFI Looking Closely at Lifeco Consolidated Capital and OSFI to Address Double-Leverage?, respectively.

If we look at, for instance, the Manulife 4Q09 Report we see that total capital is $33.2-billion, and total funds under management are $440-billion, which includes the general fund of $187-billion and seg-funds (on balance sheet, but not included in “Total Assets”) of about $192-billion.

After consolidation – particularly if mutual funds, etc., are consolidated – we could see reported total assets change dramatically:

Capital of 33.2 implies an ACM of about 14x; not only have we not been particularly thorough in digging up off-balance sheet committments, but it should also be remembered that a big chunk of these AUM are equities and should logically be constrained by a lower ACM than the banks’ loan-based accounts.

Life could well get interesting in the next few years!

The White House has published Remarks by the President on Financial Reform:

That’s why we are seeking reforms to protect consumers; we intend to close loopholes that allowed big financial firms to trade risky financial products like credit defaults swaps and other derivatives without oversight; to identify system-wide risks that could cause a meltdown; to strengthen capital and liquidity requirements to make the system more stable; and to ensure that the failure of any large firm does not take the entire economy down with it. Never again will the American taxpayer be held hostage by a bank that is “too big to fail.”

Now, limits on the risks major financial firms can take are central to the reforms that I’ve proposed. They are central to the legislation that has passed the House under the leadership of Chairman Barney Frank, and that we’re working to pass in the Senate under the leadership of Chairman Chris Dodd. As part of these efforts, today I’m proposing two additional reforms that I believe will strengthen the financial system while preventing future crises.

First, we should no longer allow banks to stray too far from their central mission of serving their customers. In recent years, too many financial firms have put taxpayer money at risk by operating hedge funds and private equity funds and making riskier investments to reap a quick reward. And these firms have taken these risks while benefiting from special financial privileges that are reserved only for banks.
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I’m proposing a simple and common-sense reform, which we’re calling the “Volcker Rule” — after this tall guy behind me. Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers. If financial firms want to trade for profit, that’s something they’re free to do. Indeed, doing so –- responsibly –- is a good thing for the markets and the economy. But these firms should not be allowed to run these hedge funds and private equities funds while running a bank backed by the American people.

In addition, as part of our efforts to protect against future crises, I’m also proposing that we prevent the further consolidation of our financial system. There has long been a deposit cap in place to guard against too much risk being concentrated in a single bank. The same principle should apply to wider forms of funding employed by large financial institutions in today’s economy. The American people will not be served by a financial system that comprises just a few massive firms. That’s not good for consumers; it’s not good for the economy. And through this policy, that is an outcome we will avoid.

Wow. This came out of the blue. But Comrade Peace-Prize needs to do something dramatic to regain the political momentum after his recent debacle.

We’re back to the days of Bush! Something this sweeping should have been announced multilaterally, and only if the world’s other big players (like, f’rinstance, the UK just for starters) agreed. Ideally it would have been done through BIS.

But it will get the political momentum back – who cares whether or not it’s unilateral?

Update: Bloomberg has picked up on the unilateralism aspect:

“This is absolutely unilateral,” said Simon Gleeson, a regulatory lawyer at Clifford Chance LLP in London. “This is Glass-Steagall Mark Two,” he added. “Banks can take just as much risk in commercial lending as they can in proprietary trading as Northern Rock and HBOS show,” he said referring to two lenders bailed out by the U.K. government.

Obama’s call “is moving a long way from the existing Basel recommendations on capital charges, which is another way of dealing with this issue,” said David Green, a former Bank of England and U.K. Financial Services Authority official who now advises regulators outside Britain.

The big problem is going to be defining “propietary”:

President Obama’s plan to curb risk- taking by banks hinges on how rigidly regulators define proprietary trading at firms such as Goldman Sachs Group Inc. and JPMorgan Chase & Co.

Goldman Sachs, which generated at least 76 percent of 2009 revenue from trading and principal investments, gets the “great majority” of transactions from customers, according to Chief Financial Officer David Viniar. About “10-ish percent” of the New York-based firm’s revenue comes from “walled-off proprietary business that has nothing to do with clients,” he said on a conference call yesterday.

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The White House defines proprietary trades as those not done for the benefit of customers, according to a senior administration official. Regulators would have the power to ask banks whether certain trades are related to client business, the official said. If they’re not, the regulators could order firms to exit the positions.

At banks such as Goldman Sachs, drawing the line isn’t easy, Viniar said.

“If a client wants to sell us a security, we’ll buy the security,” Viniar said. “That risk, which is principal risk, ends up on our balance sheet. It’s the great bulk of what we do all day long in all of our products for all our clients.”

Update 2010-1-22: I didn’t stress this before, given my shock at the concrete proposals, but I will draw attention to the deprecating phrase:

These are rules that allowed firms to act contrary to the interests of customers

Why shouldn’t firms act contrary to the interests of their counterparties? There is no fiduciary duty in a counterparty relationship when trading as principal. Zip, Zero, Zilch. Those who expect otherwise should go back to kiddie school and play some nurturing non-competitive games.

Sheila Bair of the FDIC has testified to the Financial Crisis Inquiry Commission:

In the 20 years following FIRREA and FDICIA, the shadow banking system grew much more quickly than the traditional banking system, and at the onset of the crisis, it’s been estimated that half of all financial services were conducted in institutions that were not subject to prudential regulation and supervision. Products and practices that originated within the shadow banking system have proven particularly troublesome in this crisis.
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As a result of their too-big-to-fail status, these firms were funded by the markets at rates that did not reflect the risks these firms were taking.

I don’t think it’s as cut-and-dried as that, unless she’s talking about the GSEs – which she might be. If investors underestimated risk – or estimated it correctly but got caught on the wrong side of a bet – it does not follow that they did so in the expectation of a bail-out.

This growth in risk manifested itself in many ways. Overall, financial institutions were only too eager to originate mortgage loans and securitize them using complex structured debt securities. Investors purchased these securities without a proper risk evaluation, as they outsourced their due diligence obligation to the credit rating agencies.
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Consumers and businesses had vast access to easy credit, and most investors came to rely exclusively on assessments by a Nationally Recognized Statistical Rating Agency (credit rating agency) as their due diligence. There became little reason for sound underwriting, as the growth of private-label securitizations created an abundance of AAA-rated securities out of poor quality collateral and allowed poorly underwritten loans to be originated and sold into structured debt vehicles. The sale of these loans into securitizations and other off-balance-sheet entities resulted in little or no capital being held to absorb losses from these loans. However, when the markets became troubled, many of the financial institutions that structured these deals were forced to bring these complex securities back onto their books without sufficient capital to absorb the losses. As only the largest financial firms were positioned to engage in these activities, a large amount of the associated risk was concentrated in these few firms.

Much of this is just fashionable slogan-chanting, but it is interesting to see how the rating agency problem is cast: in terms of investors outsourcing their due diligence rather than as evil rating agencies inflating their output. This is an encouraging sign, putting the onus squarely on the investors – in stark contrast to Angelides ill-advised remarks yesterday, which implied that securities firms have a responsibility to sell only products that go up.

The GSEs became highly successful in creating a market for investors to purchase securities backed by the loans originated by banks and thrifts. The market for these mortgage-backed securities (MBSs) grew rapidly as did the GSEs themselves, fueling growth in the supporting financial infrastructure. The success of the GSE market created its own issues. Over the 1990s, the GSEs increased in size as they aggressively purchased and retained the MBSs that they issued. Many argue that the shift of mortgage holdings from banks and thrifts to the GSE-retained portfolios was a consequence of capital arbitrage. GSE capital requirements for holding residential mortgage risk were lower than the regulatory capital requirements that applied to banks and thrifts.

This growth in the infrastructure fed market liquidity and also facilitated the growth of a liquid private-label MBS market, which began claiming market share from the GSEs in the early 2000’s. The private-label MBS (PLMBS) market fed growth in mortgages backed by jumbo, hybrid adjustable-rate, subprime, pay-option and Alt-A mortgages.
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These mortgage instruments, originated primarily outside of insured depository institutions, fed the housing and credit bubble and triggered the subsequent crisis. In addition, the GSEs – Fannie Mae, Freddie Mac, and the Federal Home Loan banks, were major purchasers of PLMBS.

In conjunction with her deprecation of investor acuity, this is a very interesting observation indeed!

During the 1990s, much of the underlying collateral for private-label MBSs was comprised of prime jumbo mortgages—high quality mortgages with balances in excess of the GSE loan limits. During this period, the securitizing institution would often have to retain the risky tranches of the structure because there was no active investor market for these securities.
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However, the lack of demand for the high-risk tranches limited the growth of private-label MBSs. In response, the financial industry developed two other investment structures—collateralized debt obligations (CDOs) and structured investment vehicles (SIVs). These structures were critical in creating investor demand for the high-risk tranches of the private-label MBSs and for creating the credit-market excesses that fueled the housing boom.

With these high ratings, MBS, CDO, and SIV securities were readily purchased by institutional investors because they paid higher yields compared to similarly rated securities. In some cases, securities issued by CDOs were included in the collateral pools of new CDOs leading to instruments called CDOs-squared. The end result was that a chain of private-label MBS, CDO and SIV securitizations allowed the origination of large pools of low-quality individual mortgages that, in turn, allowed over-leveraged consumers and investors to purchase over-valued housing. This chain turned toxic loans into highly rated debt securities that were purchased by institutional investors. Ultimately, investors took on exposure to losses in the underlying mortgages that was many times larger than the underlying loan balances. For regulated institutions, the regulatory capital requirements for holding these rated instruments were far lower than for directly holding these toxic loans.

The crisis revealed two fatal problems for CDOs and SIVs. First, the assumptions that generated the presumed diversification benefits in these structures proved to be incorrect. As long as housing prices continued to post healthy gains, the flaws in the risk models used to structure and rate these instruments were not apparent to investors. Second, the use of short-term asset-backed commercial paper funding by SIVs proved to be highly unstable. When it became apparent that subprime mortgage losses would emerge, investors stopped rolling-over SIVs commercial paper. Many SIVs were suddenly unable to meet their short-term funding needs. In turn, the institutions that had sponsored SIVs were forced to support them to avoid catastrophic losses. A fire sale of these assets could have cascaded and caused mark-to-market losses on CDOs and other mortgage-related securities.

OK, so we’ve identified two problems:

• regulated institutions can reduce risk-weightings by repackaging, and
• regulated institutions are “forced to support” their off-balance sheet sponsored products

Unfortunately, her proposed solution actually exacerbates the problem:

For instance, loan originators and firms that securitize these loans should have to retain some measure of recourse to ensure sound underwriting.

Interestingly:

Looking back, it is clear that the regulatory community did not appreciate the magnitude and scope of the potential risks that were building in the financial system.

For instance, private-label MBSs were originated through mortgage companies and brokers as well as portions of the banking industry. The MBSs were subject to minimum securities disclosure rules that are not designed to evaluate loan underwriting quality. Moreover, those rules did not allow sufficient time or require sufficient information for investors and creditors to perform their own due diligence either initially or during the term of the securitization.
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Many of the structured finance activities that generated the largest losses were complex and opaque transactions, and they were only undertaken by a relatively few large institutions. Access to detailed information on these activities—the structuring of the transactions, the investors who purchased the securities and other details—was not widely available on a timely basis even within the banking regulatory community.

Repeal Regulation FD!

In the mid-1990s, bank regulators working with the Basel Committee on Banking Supervision (Basel Committee) introduced a new set of capital requirements for trading activities. The new requirements were generally much lower than the requirements for traditional lending under the theory that banks’ trading-book exposures were liquid, marked-to-market, mostly hedged, and could be liquidated at close to their market values within a short interval—for example 10 days.

The market risk rule presented a ripe opportunity for capital arbitrage, as institutions began to hold growing amounts of assets in trading accounts that were not marked-to-market but “marked-to-model.” These assets benefitted from the low capital requirements of the market risk rule, even though they were in some cases so highly complex, opaque and illiquid that they could not be sold quickly without loss. Indeed, in late 2007 and through 2008, large write-downs of assets held in trading accounts weakened the capital positions of some large commercial and investment banks and fueled market fears.

In other words, regulators failed to ensure that the trading book was, in fact, trading and failed to apply a capital surcharge on aged positions.

In 2001, regulators reduced capital requirements for highly rated securities. Specifically, capital requirements for securities rated AA or AAA (or equivalent) by a credit rating agency were reduced by 80 percent for securities backed by most types of collateral and by 60 percent for privately issued securities backed by residential mortgages. For these highly rated securities, capital requirements were $1.60 per $100 of exposure, compared to $8 for most loan types and $4 for most residential mortgages.

Like the market risk rule, this rule change also created important economic incentives that altered financial institution behavior by rewarding the creation of highly rated securities from assets that previously would have been held on balance sheet. For example, as discussed earlier, the production of large volumes of AAA-rated securities backed by subprime and Alt-A mortgages was almost certainly encouraged by the ability of financial institutions holding these securities to receive preferential low capital requirements solely by virtue of their assigned ratings from the credit rating agencies.

In other words, it wasn’t just investors who were outsourcing their due diligence – they were joined by the regulators.

The federal housing GSEs operated with considerably lower capital requirements than those that applied to banks. Low capital requirements encouraged an ongoing migration of residential mortgage credit to these entities and spurred a growing reliance on the originate-to-distribute business models that proved so fragile during the crisis. Not only did the GSEs originate MBSs, they purchased private-label securities for their own portfolio, which helped support the growth in the Alt-A and subprime markets. In 2002, private-label MBSs only represented about 10 percent of their portfolio. This amount grew dramatically and peaked at just over 32 percent in 2005.

Good! A return to the role of the GSEs!

A reserve fund, built from industry assessments, would also provide economic incentives to reduce the size and complexity that makes closing these firms so difficult. One way to address large interconnected institutions is to make it expensive to be one. Industry assessments could be risk-based. Firms engaging in higher risk activities, such as proprietary trading, complex structured finance, and other high-risk activities would pay more.
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The largest firms that impose the most potential for systemic risk should also be subject to greater oversight, higher capital and liquidity requirements, and other prudential safeguards. Off-balance-sheet assets and conduits, which turned out to be not-so-remote from their parent organizations in the crisis, should be counted and capitalized on the balance sheet.

I like this part, it’s good stuff!

It’s a pity she didn’t develop her attack on the GSEs further: it seems apparent that they were the kings of the too-big-to-fail castle and had very low capital requirements. But, perhaps, she simply wants to lay the groundwork for somebody else to bell the cat.

The ABCP settlements have been released:

• Scotia (IIROC)
• Credential Securities (IIROC)
• Canaccord Financial Ltd. (IIROC)
• CIBC (OSC)
• HSBC (OSC)
• National Bank (Quebec AMF)
  • No mention of mutual fund purchases
  • No mention of National’s role as as investor in producing companies
• Laurentian (Quebec AMF)

In the Scotia agreement, the “Contraventions” section is one paragraph long:

71. The Respondent admits to the following contraventions of IIROC Rules, Guidance, IDA By-Laws, Regulations or Policies:

Between July 25 and August 10, 2007, the Respondent failed to adequately respond to emerging issues in the Coventree ABCP market insofar as it continued to sell Coventree ABCP without engaging Compliance and other appropriate processes for the assessment of such emerging issues, contrary to IDA By-law 29.1 (ii) (now Dealer Member Rule 29.1(ii)).

If we have a look at Rule 29.1:

29.1. Dealer Members and each partner, Director, Officer, Supervisor, Registered Representative, Investment Representative and employee of a Dealer Member (i) shall observe high standards of ethics and conduct in the transaction of their business, (ii) shall not engage in any business conduct or practice which is unbecoming or detrimental to the public interest, and (iii) shall be of such character and business repute and have such experience and training as is consistent with the standards described in clauses (i) and (ii) or as may be prescribed by the Board.

For the purposes of disciplinary proceedings pursuant to the Rules, each Dealer Member shall be responsible for all acts and omissions of each partner, Director, Officer, Supervisor, Registered Representative, Investment Representative and employee of a Dealer Member; and each of the foregoing individuals shall comply with all Rules required to be complied with by the Dealer Member.

The agreed statement of facts for Scotia’s “Response to Emerging Issues” is:

60. Notwithstanding the events described above, the Respondent failed to fully assess the information in the July 24th e-mail in a meaningful way. The Respondent did not notify its Compliance Department (“Compliance”) of the July 24th email or its contents until after August 13, 2007.

61. Notwithstanding its concerns about emerging market issues for Coventree ABCP, the Respondent failed to engage an adequate process to fully assess the impact of those concerns. The Respondent did not notify Compliance of its concerns.

62. Notwithstanding the emerging issues relating to the Coventree ABCP market as described above, the Respondent continued to sell Coventree ABCP to institutional clients, primarily by way of newly issued paper.

63. From July 25 to August 3, 2007, the Respondent sold Comet E from inventory, as noted in paragraph 56, and newly issued Planet A ABCP in the amount of $35,400,000, to institutional clients who the Respondent was not aware had knowledge of the US subprime exposure.

64. On August 3 the Respondent sold $28 million and from August 7 to 10 the Respondent sold $235 million in newly issued Aurora A, SAT A, and SIT III A to institutional clients (excluding sales of ABCP that matured prior to August 13, 2007 and sales to the CDPQ and other certain professional counterparties).

Update: The AMF Press Release provides more detail:

Five of the institutions involved are alleged to have failed to adequately respond to issues in the third party ABCP market, as they continued to buy and/or sell without engaging compliance and other appropriate processes for assessing such issues. Particularly, they did not disclose to all their clients the July 24th e-mail from Coventree providing the subprime exposure of each Coventree ABCP conduit.

In my essay Credit Ratings: Investors in a Bind I argued that the NRSRO exemption to Regulation FD be repealed.

This exemption may be summarized as

Regulation FD requires that an issuer, or any person acting on its behalf, publicly disclose material nonpublic information if the information is disclosed to certain specified persons. Currently, one exception to this requirement is disclosure of information to an entity whose primary business is the issuance of credit ratings, so long as the information is disclosed solely for the purpose of developing a rating and the entity’s ratings are publicly available.

The fact that credit rating agencies have access to material non-public information that you or I would go to jail for possessing can lead to considerable second-guessing when evaluating the credit quality of any given issue or issuer; encouraging an over-reliance by investors on credit rating agencies and increasing the degree of financial instability inherent in the system (by encouraging cliff-risk through market reaction to downgrades and other difficulties caused by exposure to single-point failure).

The author of the above summary, Charles A. Sweet of Bingham McCutchen LLP goes on to advise, in his post In an Effort to Encourage Unsolicited Ratings, SEC Requires Disclosure of All Information Provided to NRSROs Hired to Provide Credit Ratings; Also Adopts and Proposes Various New Disclosure Requirements for NRSROs:

The SEC has adopted, substantially as proposed, an expansion of this provision to permit the disclosure of material nonpublic information to NRSROs even if their ratings are not public. According to the SEC, this change will accommodate both subscriber-based NRSROs that do not make their ratings publicly available for free, as well as NRSROs that access information under the new disclosure rules but which do not ultimately issue a rating.

… which is great news, but not as good as the information passed on by Jim Hamilton of Jim Hamilton’s World of Securities Regulation in his post House Passes Historic Financial Overhaul Legislation:

The House of Representatives passed historic legislation today overhauling the US financial regulatory system.
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The SEC is directed to revise Regulation FD to remove from FD the exemption for entities whose primary business is the issuance of credit ratings (Section 6007).

Let’s just hope that this part of the legislation, anyway, becomes law … next stop, National Policy 51-201!

The Bank for International Settlements has released a consultative document titled Strengthening the resilience of the banking sector, which fleshes out some of the proposals made when the granted most of Treasury’s wish list immediately prior to the last G-20 meeting.

Naturally, the regulators gloss over their own responsibility for the crisis:

One of the main reasons the economic and financial crisis became so severe was that the banking sectors of many countries had built up excessive on- and off-balance sheet leverage. This was accompanied by a gradual erosion of the level and quality of the capital base. At the same time, many banks were holding insufficient liquidity buffers. The banking system therefore was not able to absorb the resulting systemic trading and credit losses nor could it cope with the reintermediation of large off-balance sheet exposures that had built up in the shadow banking system. The crisis was further amplified by a procyclical deleveraging process and by the interconnectedness of systemic institutions through an array of complex transactions. During the most severe episode of the crisis, the market lost confidence in the solvency and liquidity of many banking institutions. The weaknesses in the banking sector were transmitted to the rest of the financial system and the real economy, resulting in a massive contraction of liquidity and credit availability. Ultimately the public sector had to step in with unprecedented injections of liquidity, capital support and guarantees, exposing the taxpayer to large losses.

They emphasize their disdain for Innovative Tier 1 Capital, which has been reflected in the ratings agencies evaluations:

The remainder of the Tier 1 capital base must be comprised of instruments that are subordinated, have fully discretionary noncumulative dividends or coupons and have neither a maturity date nor an incentive to redeem. Innovative hybrid capital instruments with an incentive to redeem through features like step-up clauses, currently limited to 15% of the Tier 1 capital base, will be phased out.

Due to conflicts with the legislation to outlaw income trusts, Canadian IT1C may be cumulative-in-preferred-shares and has a maturity date. It will be most interesting to see how that works out.

Of particular interest is:

The Committee intends to discuss specific proposals at its July 2010 meeting on the role of convertibility, including as a possible entry criterion for Tier 1 and/or Tier 2 to ensure loss absorbency, and on the role of contingent and convertible capital more generally both within the regulatory capital minimum and as buffers.

Contingent Capital is discussed regularly on PrefBlog – I don’t think it’s a matter of “if”, but “when”.

One part is simply crazy:

To address the systemic risk arising from the interconnectedness of banks and other financial institutions through the derivatives markets, the Committee is supporting the efforts of the Committee on Payments and Settlement Systems to establish strong standards for central counterparties and exchanges. Banks’ collateral and mark-to-market exposures to central counterparties meeting these strict criteria will qualify for a zero percent risk weight.

A centralized institution will never fail, eh? I guess that’s because it will never, ever, do any favours for politically well-connected firms, and Iceland was the last sovereign default EVER. I think I know where the next crisis is coming from.

There is also a section on liquidity management, but it does not address a key fault of the Basel II regime: that banks holdings of other banks’ paper is risk-weighted according to the credit of the sovereign supervisor. This ensures that problems accellerate once they start – it’s like holding your unemployment contingency fund in your employer’s stock.

Let us suppose that ABC Corp. issues $1-million in paper to Bank A. Bank A finances by selling some of its paper to Bank B. Bank B has an incentive – due to risk-weighting – to buy Bank A’s paper rather than ABC’s, which makes very little sense.

They’ve finally figured out that step-ups are pretend-maturities:

“Innovative” features such as step-ups, which over time have eroded the quality of Tier 1, will be phased out. The use of call options on Tier 1 capital will be subject to strict governance arrangements which ensure that the issuing bank is not expected to exercise a call on a capital instrument unless it is in its own economic interest to do so. Payments on Tier 1 instruments will also be considered a distribution of earnings under the capital conservation buffer proposal (see Section II.4.c.). This will improve their loss absorbency on a going concern basis by increasing the likelihood that dividends and coupons will be cancelled in times of stress.

Their emphasis on “strict governance” in the above is not credible. They had all the authority they wanted during the crisis to announce that no bank considered to be at risk – or no banks at all – would not be granted permission to redeem. Instead, they rubber-stamped all the pro-forma requests for permission, making it virtually impossible for banks to act in an economically sane fashion (as Deutsche Bank found out). It’s the supervisors who need to clean up their act on this one, not the banks.

I’m pleased by the following statement:

All elements above are net of regulatory adjustments and are subject to the following restrictions:
• Common Equity, Tier 1 Capital and Total Capital must always exceed explicit minima of x%, y% and z% of risk-weighted assets, respectively, to be calibrated following the impact assessment.
• The predominant form of Tier 1 Capital must be Common Equity

I am tempted to refer to the Common Equity ratio as “Tier Zero Capital”, but I have already used that moniker for pre-funded deposit insurance.

Their list of “Criteria for inclusion in Tier 1 Additional Going Concern Capital” is of immense interest, since this will include preferred shares:

8. Dividends/coupons must be paid out of distributable items
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11. Instruments classified as liabilities must have principal loss absorption through either
(i) conversion to common shares at an objective pre-specified trigger point or (ii) a
write-down mechanism which allocates losses to the instrument at a pre-specified
trigger point. The write-down will have the following effects:
a. Reduce the claim of the instrument in liquidation;
b. Reduce the amount re-paid when a call is exercised; and
c. Partially or fully reduce coupon/dividend payments on the instrument.

Regretably, they do not provide a definition of “distributable items”. I suspect that this means that preferred dividends may not be considered return of capital and that they must come out of non-negative retained earnings, but it’s not clear.

One interesting thing is:

Minority interest will not be eligible for inclusion in the Common Equity component of Tier 1.

The next quotation has direct impact on Citigroup, particularly:

Deferred tax assets which rely on future profitability of the bank to be realised should be deducted from the Common Equity component of Tier 1. The amount of such assets net of deferred tax liabilities should be deducted.

All in all, the document has a certain amount of high-level interest, but the real meat is yet to come.