PrefBlog

The Banking Subcommittee of the Bank for International Settlements has released a consultation paper titled Capitalisation of bank exposures to central counterparties:

Generally speaking, the Committee proposes that trade exposures to a qualifying CCP will receive a 2% risk weight. In addition, default fund exposures to a CCP will, in accordance with a risk sensitive waterfall approach (based on a CCP’s actual financial resources and hypothetical capital requirements), be capitalised according to a method that consistently and simply estimates risk arising from such default fund.

As has been discussed on PrefBlog, the purpose of Central Counterparties is to increase the vulnerability of the global financial system to single-point failure, and to provide additional extra-judicial power to bureaucrats who will be empowered to decide who gets to be a member of the Clearing Corporation.

This is considered to be far superior to a system in which the bank at risk makes a credit assessment and, when a trade is going their way, either gets collateral for the exposure or accepts an increment to Risk-Weighted Assets. Such a system would require banks such as CIBC to be as thoughtful about their counterparty exposure as Goldman Sachs; decent risk-management procedures in the industry would leave regulators with less to do.

With the new system, CIBC will be able to load up the Central Counterparty with billions in exposure to the Bank of Downtown Medicine Hat, without having to worry overmuch about its credit quality – the exposure will be covered by the other clearinghouse members.

One of the great problems with the Panic of 2007, we are told, was moral hazard. What I initially misunderstood was the regulators’ attitude: it’s not that they feel there was too much of it; they feel that there wasn’t enough, so they have designed a system to create more.

Sic transit gloria mundi.

The Basel Committee on Banking Supervision has released the Basel III: A global regulatory framework for more resilient banks and banking systems:

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 (CPSS) and the International Organization of Securities Commissions (IOSCO) to establish strong standards for financial market infrastructures, including central counterparties. The capitalisation of bank exposures to central counterparties (CCPs) will be based in part on the compliance of the CCP with such standards, and will be finalised after a consultative process in 2011. A bank’s collateral and mark-to-market exposures to CCPs meeting these enhanced principles will be subject to a low risk weight, proposed at 2%; and default fund exposures to CCPs will be subject to risk-sensitive capital requirements. These criteria, together with strengthened capital requirements for bilateral OTC derivative exposures, will create strong incentives for banks to move exposures to such CCPs. Moreover, to address systemic risk within the financial sector, the Committee also is raising the risk weights on exposures to financial institutions relative to the non-financial corporate sector, as financial exposures are more highly correlated than non-financial ones.

It is worthwhile thinking about how the CCP exposure will blow up – because it will, never fear! I have often stressed the poor design inherent in developing a system so exposed to long-term single point failure, but the desperate need of the regulators to be seen as doing something has overwhelmed such antiquated notions as common sense.

On the other hand, it is good to see that risk-weights on exposure to financial institutions is being raised, but the details need to be examined. Unfortunately, they appear to apply only to collateralized derivative transactions, not to bank paper itself.

They also tout the introduction of a leverage ratio cap:

One of the underlying features of the crisis was the build up of excessive on- and off-balance sheet leverage in the banking system. The build up of leverage also has been a feature of previous financial crises, for example leading up to September 1998. During the most severe part of the crisis, the banking sector was forced by the market to reduce its leverage in a manner that amplified downward pressure on asset prices, further exacerbating the positive feedback loop between losses, declines in bank capital, and the contraction in credit availability. The Committee therefore is introducing a leverage ratio requirement that is intended to achieve the following objectives:

• constrain leverage in the banking sector, thus helping to mitigate the risk of the destabilising deleveraging processes which can damage the financial system and the economy; and
• introduce additional safeguards against model risk and measurement error by supplementing the risk-based measure with a simple, transparent, independent measure of risk.

  17. The leverage ratio is calculated in a comparable manner across jurisdictions, adjusting for any differences in accounting standards. The Committee has designed the leverage ratio to be a credible supplementary measure to the risk-based requirement with a view to migrating to a Pillar 1 treatment based on appropriate review and calibration.

The previously agreed capital requirements are confirmed:

All elements above are net of the associated regulatory adjustments and are subject to the following restrictions (see also Annex 1):

• Common Equity Tier 1 must be at least 4.5% of risk-weighted assets at all times.
• Tier 1 Capital must be at least 6.0% of risk-weighted assets at all times.
• Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 8.0% of risk-weighted assets at all times.

Of greatest interest to preferred share investors are the rules regarding eligibility for inclusion in “Additional Tier 1 Capital”. Most of this is a simple continuation of extant rules, but:

Dividend/coupon discretion:
a. the bank must have full discretion at all times to cancel distributions/payments(footnote)
b. cancellation of discretionary payments must not be an event of default
c. banks must have full access to cancelled payments to meet obligations as they fall due
d. cancellation of distributions/payments must not impose restrictions on the bank except in relation to distributions to common stockholders.

footnote: A consequence of full discretion at all times to cancel distributions/payments is that “dividend pushers” are prohibited. An instrument with a dividend pusher obliges the issuing bank to make a dividend/coupon payment on the instrument if it has made a payment on another (typically more junior) capital instrument or share. This obligation is inconsistent with the requirement for full discretion at all times. Furthermore, the term “cancel distributions/payments” means extinguish these payments. It does not permit features that require the bank to make distributions/payments in kind.

Heretofore, it has been possible (unlikely, but possible) that preferred shares could default while Innovative Tier 1 Capital pays in full. If I’m reading this section correctly, the footnote means that, in principle if not necessarily in practice, all elements of Tier 1 Capital will be parri passu.

The footnote nearly gave me a heart attack, as in and of itself it appears to prohibit the preference of dividends; however, such an interpretation conflicts with point (d), which explicitly allows seniority to common.

Also of interest is section 12:

Neither the bank nor a related party over which the bank exercises control or significant influence can have purchased the instrument, nor can the bank directly or indirectly have funded the purchase of the instrument.

This would appear to prohibit margining in stock accounts. Come to think of it, I’m not sure if this has ever been addressed: can you buy TD common on margin in your TDW account?

The discussion of subordinated debt is interesting:

May be callable at the initiative of the issuer only after a minimum of five years:
a. To exercise a call option a bank must receive prior supervisory approval;
b. A bank must not do anything that creates an expectation that the call will be exercised;(19) and
c. Banks must not exercise a call unless:
i. They replace the called instrument with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank(20); or
ii. The bank demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised.(21)

Footnotes:

(19) An option to call the instrument after five years but prior to the start of the amortisation period will not be viewed as an incentive to redeem as long as the bank does not do anything that creates an expectation that the call will be exercised at this point.

(20) Replacement issues can be concurrent with but not after the instrument is called.

(21) Minimum refers to the regulator’s prescribed minimum requirement, which may be higher than the Basel III Pillar 1 minimum requirement.

In Canada, one wonders whether footnote (19) will prohibit bank-owned brokerages from quoting the yields on sub-debt to a presumed maturity due to a call at the start of the amortization period. It should; but this might damage the long term career prospects of OSFI personnel, so I’m not holding my breath.

Market pressures – due to the way sub-debt is sold – are so extreme as to make the call de facto mandatory; it is very disappointing that BIS is not addressing this problem.

Given the abuses that have ocdurred in the sub-debt market over the past few years due to market expectation of such a call, I am rather disappointed to see that such calls are still allowable.

Of interest to Citigroup is:

69. Deferred tax assets (DTAs) that rely on future profitability of the bank to be realised are to be deducted in the calculation of Common Equity Tier 1.

Citigroup now has a Tier 1 Capital Common Ratio of 2.16% and a Tier 1 Capital Ratio of 11.92%; although it looks like they’re playing games in the press release:

Citi remained one of the best capitalized banks with $125.4 billion of Tier 1 Capital and a Tier 1 Common ratio of 10.3% at the end of the third quarter 2010.

When in doubt, invent a new non-GAAP, non-BIS ratio, that’s what I say! The 2009 Annual Report is more forthcoming with calculation methodologies:

Of Citi’s approximately $46 billion of net deferred tax assets at December 31, 2009, approximately $15 billion of such assets were includable without limitation in regulatory capital pursuant to risk-based capital guidelines, while approximately $26 billion of such assets exceeded the limitation imposed by these guidelines and, as “disallowed deferred tax assets,” were deducted in arriving at Tier 1 Capital. Citigroup’s other approximately $5 billion of net deferred tax assets primarily represented approximately $3 billion of deferred tax effects of unrealized gains and losses on available-for-sale debt securities and approximately $2 billion of deferred tax effects of the pension liability adjustment, which are permitted to be excluded prior to deriving the amount of net deferred tax assets subject to limitation under the guidelines. Citi had approximately $24 billion of disallowed deferred tax assets at December 31, 2008.

Back to BIS … I’m very pleased to see this:

Banks are also required to make available on their websites the full terms and conditions of all instruments included in regulatory capital. The Basel Committee will issue more detailed Pillar 3 disclosure requirements in 2011.

Also of interest are the specifics of the Capital Conservation Buffer:

131. The table below shows the minimum capital conservation ratios a bank must meet at various levels of the Common Equity Tier 1 (CET1) capital ratios. For example, a bank with a CET1 capital ratio in the range of 5.125% to 5.75% is required to conserve 80% of its earnings in the subsequent financial year (ie payout no more than 20% in terms of dividends,share buybacks and discretionary bonus payments). If the bank wants to make payments in excess of the constraints imposed by this regime, it would have the option of raising capital in the private sector equal to the amount above the constraint which it wishes to distribute. This would be discussed with the bank’s supervisor as part of the capital planning process. The Common Equity Tier 1 ratio includes amounts used to meet the 4.5% minimum Common Equity Tier 1 requirement, but excludes any additional Common Equity Tier 1 needed to meet the 6% Tier 1 and 8% Total Capital requirements. For example, a bank with 8% CET1 and no Additional Tier 1 or Tier 2 capital would meet all minimum capital requirements, but would have a zero conservation buffer and therefore by subject to the 100% constraint on capital distributions.

Unfortunately, the Countercyclical Buffer remains a matter of regulatory discretion:

Each Basel Committee member jurisdiction will identify an authority with the responsibility to make decisions on the size of the countercyclical capital buffer. If the relevant national authority judges a period of excess credit growth to be leading to the build up of system-wide risk, they will consider, together with any other macroprudential tools at their disposal, putting in place a countercyclical buffer requirement. This will vary between zero and 2.5% of risk weighted assets, depending on their judgement as to the extent of the build up of system-wide risk.

The leverage cap looks pretty loose

The Committee will test a minimum Tier 1 leverage ratio of 3% during the parallel run period from 1 January 2013 to 1 January 2017.
…
161. Banks should calculate derivatives, including where a bank sells protection using a credit derivative, for the purposes of the leverage ratio by applying:

• the accounting measure of exposure plus an add-on for potential future exposure calculated according to the Current Exposure Method as identified in paragraphs 186, 187 and 317 of the Basel II Framework. This ensures that all derivatives are converted in a consistent manner to a “loan equivalent” amount; and
• the regulatory netting rules based on the Basel II Framework.

(iii) Off-balance sheet items
162. This section relates to off-balance sheet (OBS) items in paragraphs 82-83, (including 83(i)), 84(i-iii), 85-86, and 88-89) of the Basel II Framework. These include commitments (including liquidity facilities), unconditionally cancellable commitments, direct credit substitutes, acceptances, standby letters of credit, trade letters of credit, failed transactions and unsettled securities. The treatment of the items included in 83(ii) and 84, ie repurchase agreements and securities financing transactions is addressed above.

163. The Committee recognises that OBS items are a source of potentially significant leverage. Therefore, banks should calculate the above OBS items for the purposes of the leverage ratio by applying a uniform 100% credit conversion factor (CCF).

164. For any commitments that are unconditionally cancellable at any time by the bank without prior notice, banks should apply a CCF of 10%. The Committee will conduct further review to ensure that the 10% CCF is appropriately conservative based on historical experience.

It’s going to take quite a while to digest all this!