PrefBlog

The Bank for International Settlements has tweaked its capital rules, announcing:

At its 8-9 July meeting, the newly expanded Basel Committee on Banking Supervision approved a final package of measures to strengthen the 1996 rules governing trading book capital and to enhance the three pillars of the Basel II framework.

Most of the modifications have to do with securitizations. The document Enhancements to the Basel II framework gives the details; the most interesting – to me! – extracts are:

During the recent market turmoil, several banks that provided LFs to ABCP programmes chose to purchase commercial paper issued by the ABCP conduit instead of having the conduit draw on its LF. The LF provider then risk weighted the ABCP based on the paper’s external rating. As a result, the LF provider benefited from the external rating on the commercial paper when assigning a risk weight to that paper, even though the rating was due in large part to the bank’s own support of the conduit in the form of the LF.

That particular loophole has been plugged!

In a nod to the political needs of the Canadian government, GMD facilities (which became one of the scapegoats for the non-bank ABCP fiasco) have been eliminated:

More specifically, paragraph 580 states that banks may apply a 0% CCF to eligible liquidity facilities that are only available in the event of a general market disruption (ie where more than one SPE across different transactions are unable to roll over maturing commercial paper, and that inability is not the result of an impairment in the SPEs’ credit quality or in the credit quality of the underlying exposures). Paragraph 638 states that an eligible liquidity facility that can only be drawn in the event of a general market disruption is assigned a 20% CCF under the SF. That is, an IRB bank is to recognise 20% of the capital charge generated under the SF for the facility.

The framework has been changed to eliminate paragraphs 580 and 638, in the SA and IRB Approach, respectively. This eliminates any favourable treatment accorded to market disruption liquidity facilities under Basel II.

I asked OSFI if they had any examples of a GMD line causing problems for a bank when the the GMD line was independent of reputational concern. With their customary aplomb, OSFI has declined to answer the question.

The section on Supervision discusses reputational risk:

Reputational risk can be defined as the risk arising from negative perception on the part of customers, counterparties, shareholders, investors, debt-holders, market analysts, other relevant parties or regulators that can adversely affect a bank’s ability to maintain existing, or establish new, business relationships and continued access to sources of funding (eg through the interbank or securitisation markets).
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A bank should incorporate the exposures that could give rise to reputational risk into its assessments of whether the requirements under the securitisation framework have been met and the potential adverse impact of providing implicit support.
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Reputational risk also arises when a bank sponsors activities such as money market mutual funds, in-house hedge funds and real estate investment trusts (REITs). In these cases, a bank may decide to support the value of shares/units held by investors even though is not contractually required to provide the support.
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For instance, to avoid damaging its reputation, a bank may call its liabilities even though this might negatively affect its liquidity profile. This is particularly true for liabilities that are components of regulatory capital, such as hybrid/subordinated debt.
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By providing implicit support, a bank signals to the market that all of the risks inherent in the securitised assets are still held by the organisation and, in effect, had not been transferred. Since the risk arising from the potential provision of implicit support is not captured ex ante under Pillar 1, it must be considered as part of the Pillar 2 process.

There are also changes to calculation of market risk for the trading book:

In October 2007, the Basel Committee on Banking Supervision (the Committee) released guidelines for computing capital for incremental default risk for public comments. At its meeting in March 2008, it reviewed comments received and decided to expand the scope of the capital charge. The decision was taken in light of the recent credit market turmoil where a number of major banking organisations have experienced large losses, most of which were sustained in banks’ trading books. Most of those losses were not captured in the 99%/10-day VaR. Since the losses have not arisen from actual defaults but rather from credit migrations combined with widening of credit spreads and the loss of liquidity, applying an incremental risk charge covering default risk only would not appear adequate. For example, a number of global financial institutions commented that singling out just default risk was inconsistent with their internal practices and could be potentially burdensome.

The incremental risk charge (IRC) is intended to complement additional standards being applied to the value-at-risk modelling framework.

This is a major issue for insurers. Assiduous Readers may recall that one of the issues regarding capital adequacy of insurers is their practice of estimating bond risk without consideration of price; if the rating – or their internal analysis – indicated a 0.1% chance of default, say, that’s what was used for risk purposes, regardless of whether the bond was trading at governments +10bp or governments +500bp. To some extent this is rational; to some extent it ain’t. The question of how forcefully this idea is applied to the investment book of insurers will be a fascinating subject over the next few years.

These BIS tweaks further extend into the calculation of market risks.

The Office of the Superintendent of Financial Institutions has announced:

The Office of the Superintendent of Financial Institutions and the Canadian P&C insurance industry are working together through the Minimum Capital Test (MCT) Advisory Committee to develop more advanced risk measurement techniques (internal models) for incorporation into the MCT / Branch Adequacy of Assets Test. These techniques will include the development of risk management and disclosure criteria for risk-sensitive methodologies for use by companies that have the commitment and resources to implement them.

The MCT Advisory Committee has developed and proposed a set of high level key principles to guide the development of a new capital framework. Please provide your comments by August 31, 2009.

This is significant. In the past I have harshly criticized OSFI’s lack of consultation. There’s no way of telling at this point whether this is genuine consultation or merely window-dressing, but it is undeniably a step forward.

The Key Principles are, unfortunately, so generic as to be useless. Like, f’rinstance:

Capital requirements should be risk-based.

It’s pretty hard to argue about that!

The section that might prove contentious is:

To allow market discipline, the meaning and methodology for, and the factual disclosure related to, regulatory capital and capital requirements should be transparent.

Assiduous Readers will know of my long-standing complaint about the lack of disclosure of the double-leverage inherent in the holdco/sub structure. The accompanying letter provides information regarding submission of comments:

For comments or questions, please contact Bernard Dupont at (613)990-7797 or bernard.dupont@osfi-bsif.gc.ca or Judith Roberge at (613) 990-4412 or judith.roberge@osfi-bsif.gc.ca.

I suggest that all those with an interest in the preferred shares issued by P&C holdcos (e.g., ELF.PR.F, ELF.PR.G) write in and suggest that ownership of a controlling interest in a P&C operating company be made conditional on the holdco publishing deconsolidated financial statements.

And, with respect to procedure, it will also be worthwhile to suggest that

• All comments be made public
• The response of the committee to the comments be published

Well … it looks like they’re coming. Accrued Interest will be happy.

Treasury today unveiled its new website, with a press release on the previously touted regulation of OTC derivatives:

Promoting Efficiency And Transparency Within The OTC Markets — To ensure regulators would have comprehensive and timely information about the positions of each and every participant in all OTC derivatives markets, this new framework includes: Amending the CEA and securities laws to authorize the CFTC and the SEC to impose:

• Recordkeeping and reporting requirements (including audit trails).
• Requirements for all trades not cleared by CCPs to be reported to a regulated trade repository.
• CCPs and trade repositories must make aggregate data on open positions and trading volumes available to the public.
• CCPs and trade repositories must make data on individual counterparty’s trades and positions available to federal regulators.
• The movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems.
• The development of a system for the timely reporting of trades and prompt dissemination of prices and other trade information.
• The encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives.

Credit Default Swaps are not mentioned specifically in the press release, but clearly fall under the heading of “OTC Derivatives” and “standardized trades” … at least, the plain-vanilla ones do.

I think it’s a mistake. OTC markets reward those with a vague idea of what they’re doing; the transparency of an exchange gives incompetent advisors a free ride. On the bright side, it will at least dampen the endless whining for centralized bond exchanges that accompany every discussion of bond market reform … once Joe Retail sees that, for instance, a CDS on CM at 500bp with an end-date of April 10, 2013 traded 2 contracts last month and are quoted at a 200bp spread, perhaps he won’t feel so hard done by when looking at dealer quotes for his $5,000 lot.

No argument is presented in favour of the idea. The closest approach is the opening paragraph:

As the AIG situation has made clear, massive risks in derivatives markets have gone undetected by both regulators and market participants. But even if those risks had been better known, regulators lacked the proper authorities to mount an effective policy response.

… which, as I’m sure Geithner knows perfectly well is totally ficticious. It would have been the easiest thing in the world for the Fed to have altered bank capitalization rules (and for the SEC to have altered broker capitalization rules) to have required more margin (or capital charges in lieu thereof) for swaps.

In which case, AIG’s ability to sell uncollateralized protection to the financial system behemoths would have been sharply curtailed, and direct damage limited to non-regulated entitites. However, this would involve regulators ‘fessing up to inadequacy, which ain’t gonna happen.

The Canadian Press reports that Mark Carney has proposed yet another regulator (while, I suspect, coughing and pointing at himself):

The central bank governor told a Senate committee that the country’s regulatory fiefdoms need a new mechanism to ensure individual financial watchdogs do not have blinders on that prevents them from seeing the bigger picture.

Carney said the central bank had warned years in advance about the risks involved with the $32-billion non-bank asset-backed commercial paper market, but its cautions were ignored.

“We view ourselves as having an advocacy role identifying problems and making them known,” he said.

“The advice has not always been followed, and in some cases problems have been repeatedly identified.

“In one case, the issue was really the only serious capital market problem we have had in this crisis (and) had been identified by the bank some years in advance.”
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Carney’s argument for what he called a new “mechanism” that would require individual regulators to consider the wider implications of their actions came at the conclusion of a two-hour hearing with the Senate banking committee.

Unfortunately, there is no mention of such a thing in the Official Opening Remarks.

Let’s recapitulate, shall we?

The seeds of the ABCP fiasco were sown long ago, when OSFI required that banks put up capital for undrawn, guaranteed lines of credit (“Global Liquidity”). They did not require capital for undrawn vague committments, such as the General Market Disruption clause. I consider this to have been an entirely prudent ruling. For this reason, the ABCP market in Canada relied on GMD agreements, since Global Liquidity cost too much extra.

In the States, the Fed did not require capital for Global Liquidity; since it did not require capital it was cheap; since it was cheap that’s what ABCP issuers chose.

Later, the Fed changed their rules to be more consistent with the Canadian approach. At that time, the US ABCP market was sufficiently well-established that the extra costs were absorbed. Canadian issuers did not change their ways because there was no point: there would have been extra costs for whoever went first with no competitive advantage.

In 2003 the Bank of Canada published a warning about ABCP – well done BoC and I hope Paula Toovey and John Kiff get bonuses!

By 2007, the market was a little bit rigged: an enormous fraction of outstanding Canadian ABCP was held by accounts controlled/advised by entities that also had ownership interests in producers. There has never been a satisfactory explanation – public and satisfactory to me, anyway – of whether the portfolio managers responsible for the accounts holding the paper were motivated solely by concerns about the best interests of the accounts they were managing.

In mid/late 2007 the market collapsed. It became apparent that there were many holders of ABCP who were enormously concentrated in the asset class, if not a single name within that asset class. As far as I know, not a single PM has lost his license due to over-concentration. The regulatory response has concentrated on investment suitability, which I don’t understand at all. Even with hindsight, I consider non-Bank Canadian ABCP to be a suitable money-market investment that, unfortunately went bad. Please note that the word “suitable” means “on the list”. It means “sure, consider this stuff for inclusion in a diversified portfolio”. It does not mean “back up the trucks, guys, and load up 100% in this paper”. If that’s what the word “suitable” meant, NOTHING would be “suitable”.

I have not yet heard of anybody losing their license – or even being charged – for concentration risk.

Some people got burned and got burned badly, sure. That’s what happens when you load up on a single sure-fire can’t-miss investment. The only systemic implications I have seen is that some financial institutions were forced for reputational reasons to take the defaulted paper onto their books at par, without this reputational risk having been accounted for as part the financial institutions’ capital requirements.

This reputational risk needs to be addressed in Basel 3, if not sooner. As I have urged, for instance, the assets held by bank-sponsored money market funds should be included in Risk-Weighted Assets for capital calculation purposes. I have not yet heard any argument as to why such a course of action is not both necessary and sufficient.

The Fed has announced:

the adoption of a final rule that delays until March 31, 2011, the effective date of new limits on the inclusion of trust preferred securities and other restricted core capital elements in tier 1 capital of bank holding companies (BHCs).

The final rule explains:

Under limits on restricted core capital elements that are currently in effect, a BHC generally may include in tier 1 capital cumulative perpetual preferred stock and trust preferred securities up to 25 percent of the sum of core capital elements (including cumulative perpetual preferred stock and trust preferred securities). The new limits would limit restricted core capital elements includable in the tier 1 capital of a BHC to 25 percent of the sum of core capital elements (including restricted core capital elements), net of goodwill less any associated deferred tax liability. In addition, internationally active BHCs would be subject to a further limitation.

In particular, the amount of restricted core capital elements (other than qualifying mandatory convertible preferred securities) that an internationally active BHC could include in tier 1 capital could not exceed 15 percent of the sum of core capital elements (including restricted core capital elements), net of goodwill less any associated deferred tax liability.
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In light of conditions in the capital markets, the Board has considered whether an additional extension of the effective date of the new limits is appropriate. The economic conditions for the past 18 months, and currently, have created a situation in which requiring adherence to the new limits by the March 31, 2009, effective date creates a substantial burden for many BHCs in a way that was not anticipated when the final rule was adopted in 2005. In the prevailing market conditions, it is especially important for BHCs to expend efforts to increase their overall capital levels, although it is challenging to do so now through retention of earnings, the most typical means. Therefore, to promote stability in the financial markets and the banking industry as a whole, the Board has decided to further delay the effective date of the new limits until March 31, 2011. The Board believes that this extended transition period would allow affected BHCs sufficient flexibility to satisfy the Board’s risk-based and leverage capital guidelines during the current stressed market conditions.

The Bank for International Settlements has announced (via the Basel Committee on Banking Supervision):

that the level of capital in the banking system needs to be strengthened to raise its resilience to future episodes of economic and financial stress. This will be achieved by a combination of measures such as introducing standards to promote the build up of capital buffers that can be drawn down in periods of stress, strengthening the quality of bank capital, improving the risk coverage of the capital framework and introducing a non-risk based supplementary measure. Also, the regulatory minimum level of capital will be reviewed in 2010, taking into account the above and other relevant factors to arrive at a total level and quality of capital that is higher than the current Basel II framework. Strengthening the global capital framework in this manner will enhance confidence and lay the foundation for a more resilient banking system.

The Committee notes that current reactions in the market place regarding capital levels have been highly procyclical. It will not increase global minimum capital requirements during this period of economic and financial stress. Indeed, the Committee has earlier stated that capital buffers above the regulatory minimum are designed to absorb losses and support continued lending to the economy.

We can hope that OSFI signs on to the bit about increasing bank capital quality! The important issue being discussed is the “build up of capital buffers” – one of the issues in the current crisis is that bank capital as currently defined may be all very well and good in terms of protecting depositors when a bank is wound-up, but doesn’t help too much when a bank gets into trouble and needs to recapitalize. A system of surcharges based on asset growth would go a long way towards fixing this problem.

I will bet a nickel that the “non-risk based supplementary measure” is the leverage ratio (US nomenclature) / Assets-to-Capital Multiple (Canadian nomenclature).

I am very disappointed that there is no mention of the influence of bank size. A Megabank has so many layers of management that the Board’s Risk Committee – comprised, generally, of people who are appointed for their gender and/or connections, nothing to do with ability – has many, many layers of self-interested subordinates between it and the guts of the matter.

Their other announcement is a joint paper with the International Association of Deposit Insurers. The consultative document is open for comments – hear that, OSFI? Comments from affected parties! How revolutionary! – until May 15. I suspect that debate between Iceland and the UK will be highly entertaining, as briefly review on Guy Fawkes’ Day.

Update: I also note a recent speech by David Longworth, Deputy Governor of the Bank of Canada:

Now, the assumption that most market participants use the same risk-management systems based on short historical samples is very much an exaggeration. Some researchers, however, have argued that enough institutions follow very similar risk-management systems that the dynamics described above can happen, and indeed have happened, in the real world in response to sizable shocks.¹⁴ Moreover, in its Global Financial Stability Report issued in the second half of 2007, the International Monetary Fund concluded – based on simulations it carried out, which seemed realistic based on observed risk-management practices – that “seemingly prudent behavior by individual firms, reacting to similar market-risk systems, could serve to amplify market volatility in periods of stress beyond what would otherwise have occurred.”¹⁵ Observations and anecdotal information following the failure of Lehman Brothers suggest that this behaviour of firms was very important in amplifying price volatility in the autumn of 2008. Analysis of such behaviour strongly suggests the need for a macroprudential approach.

[Footnotes]14. See A. Persaud (previous footnote) and the Committee on the Global Financial System, “A Review of Financial Market Events in Autumn 1998” (CGFS Publications No.12, Bank for International Settlements, 1999). This latter text has a section (see page 14) on the over-reliance on quantitative tools.

15. International Monetary Fund, “Do Market Risk Management Techniques Amplify Systemic Risks?” in Global Financial Stability Report October 2007, 52-76.

Cliff risk due to similarity of trading techniques (that is, the “best practices” so beloved of bureaucracies) were last discussed on PrefBlog on March 12. It has been a worry for BoC for a long time.

Back to David Longworth:

Two main principles have been proposed. The first is that, in parallel with the probability of default on credit exposures on the banking book being calculated on a “through-the-cycle” basis, VaR for the trading book also be calculated on a through-the-cycle basis. One implication of this principle is that all historical data should be exploited to calculate the distribution of possible losses for a given asset or asset class. The second principle is that a “stress VaR” – a VaR calculated on the basis of assumed stress conditions – should be used, especially to consider the heightened correlation of losses across various assets or asset classes. It is well known that correlations among losses in categories of risky assets increase dramatically (sometimes approaching one), when the financial system is under great stress.

I have problems with the “through the cycle” approach. It throws out a lot of data; and should a firm become insolvent it doesn’t mean a lot to say ‘well, we’re solvent through the cycle, so trust me!’ There is a reason for cycles; recessions are nature’s way of telling us we’re doing something wrong. The problem should be attacked from the other end, focussing on capital.

The “stress VaR” is nothing more nor less than common sense.