Interesting post from Capital Issues on the issue of “Badwill accounting”. It is based on a post by Adrian Docherty but goes into more detail on the mechanics of why there is no free lunch when you acquire a bank for less than its book value.
Badwill accounting
I came across this blog post by Bryan Lehrer titled “Costco Capitalism” which I think offers an interesting variation on the discussion of companies seeking to do good, or even better, to “be” good.
It poses two questions:
This extract will give you a flavour of the author’s analysis of the Costco business model
Sustainable Capitalism? – What Costco shows us about the blurry relationship between ethical and fair
Costco shows that … simply providing your customers the feeling that they aren’t getting ripped off, and doing so in a way that matches mainstream views of acceptable externalities, is all that is required for success. If this sounds reductive, it’s because it is. The key to Costco’s success is just how straightforward the alignment of stakeholders within its business model are.
That being said, there are externalities associated with Costco’s business model, even if they aren’t viewed by the mainstream as such. The main thing here is a retail model that promotes rampant consumption, and the fallout from this which includes broad waste and sustainability concerns. Interestingly, because of Costco’s large purchasing power, dominance over its supply chains, and upper-middle class income of its shoppers, it generally has more progressive product standards than other retail brands in comparable price tiers.
Costco Capitalism, Bryan Lehrer
Lehrer argues that the foundation is to provide customers with “the feeling that they aren’t getting ripped off“ thereby building that elusive intangible asset of Trust that many companies routinely include in their statement of corporate values (e.g. “a Trusted Partner”). However, equally important is that the company can do this “in a way that matches mainstream views of acceptable externalities“.
This qualification regarding externalities is the interesting part.
Other companies may have a credible claim to being able to provide a good or service cheaply but the often unasked question is what is the full cost of the good or service; i.e. is the low cost at the company/consumer level based on paying workers a subsistence wage with uncertain working hours, or reliance on an external supply chain with dubious environmental and labour standards. Lehrer notes that Costco could be vulnerable to criticism on a number of fronts (e.g. its business is, at its heart, a mass consumption model) but Costco is protected by virtue of adopting a position which fits community standards. Costco can afford to spend some of its efficiency dividend on progressive product standards but it is not necessarily pushing the boundaries of what might be done because it is also sensitive to what its customers are willing to pay for being good.
This framework (i.e. is our business built on an operating model that is structurally fair) offers a useful perspective when thinking about financial services companies. Initiatives such as the Bankers’ Oath have a contribution to make in addressing the cultural issues in banking but I suspect that there is as much value (potentially more) in exploring the structural features of the industry that create the pressure to cut corners in the pursuit of financial targets.
I don’t expect anyone will change their mind about bankers and banking in general on the basis of this post. I do hope to make the point that there are subtle structural challenges in banking that complicate the capacity to do good. Developing a better understanding of the structural issues is I think essential to crafting a lasting solution to the cultural issues. I don’t have any neat answers but I do feel that the issues covered in Bryan Lehrer’s analysis of Costco offer some insights.
Tony – From the Outside
The RBNZ just released the results of the stress testing conducted by itself and a selection of the larger NZ banks to test resilience to the risks posed by COVID 19.
The extract below summarises the process the RBNZ followed and its key conclusions:
COVID-19 stress test consisted of two parts. First, a desktop stress test where the Reserve Bank estimated the impact on profitability and capital for nine of New Zealand’s largest banks to the impact of two severe but plausible scenarios. Second, the Reserve Bank coordinated a process in which the five largest banks used their own models to estimate the effect on their banks for the same scenarios.
The pessimistic baseline scenario can be characterised as a one-in-50 to one-in-75 year event with the unemployment rate rising to 13.4 percent and a 37 percent fall in property prices. In the very severe scenario, the unemployment rate reaches 17.7 percent and house prices fall 50 percent. It should be noted that these scenarios are hypothetical and are significantly more severe than the Reserve Banks’ baseline scenario.
The overall conclusion from the Reserve Bank’s modelling is that banks could draw on their existing capital buffers and continue lending to support lending in the economy during a downturn of the severity of the pessimistic baseline scenario. However, in the more severe scenario, banks capital fell below the regulatory minimums and would require significant mitigating actions including capital injections to continue lending. This reinforces the need for strong capital buffers to provide resilience against severe but unlikely events.
The results of this stress test supports decisions that were made as part of the Capital Review to increase bank capital levels. The findings will help to inform Reserve Bank decisions on the timing of the implementation of the Capital Review, and any changes to current dividend restrictions.
“Outcome from a COVID-19 stress test of New Zealand banks”, RBNZ Bulletin Vol 83, No 3 September 2020
I have only skimmed the paper thus far but there is one detail I think worth highlighting for anyone not familiar with the detail of how bank capital adequacy is measured – specifically the impact of Risk Weighted Assets on the decline in capital ratios.
The RBNZ includes two useful charts which decompose the aggregate changes in CET1 capital ratio by year two of the scenario.
In the “Pessimistic Baseline Scenario”(PBS), the aggregate CET1 ratio declines 3.7 percentage points to 7.7 percent. This is above both the regulatory minimum and the threshold for mandatory conversion of Additional Tier 1 Capital. What I found interesting was that RWA growth contributed 2.2 percentage points to the net decline.
The RBNZ quite reasonably points out that banks will amplify the downturn if they restrict the supply of credit to the economy but I think it is also reasonable to assume that the overall level of loan outstandings is not growing and may well be shrinking due to the decline in economic activity. So a substantial portion of the decline in the aggregate CET1 ratio is due to the increase in average risk weights as credit quality declines. The C ET1 ratio is being impacted not only by the increase in impairment expenses reducing the numerator, there is a substantial added decline due to the way that risk weighted assets are measured
In the “Very Severe Scenario”(VSS), the aggregate CET1 ratio declines 5.6 percentage points to 5.8 percent. The first point to note here is that CET1 only remains above the 4.5% prudential minimum by virtue of the conversion of 1.6 percentage points of Additional Tier 1 Capital. Assuming 100% of AT1 was converted, this also implies that the Tier 1 ratio is below the 6.0% prudential minimum.
These outcomes provide food for thought but I few points I think wroth considering further before accepting the headline results at face value:
As always, it is entirely possible that I am missing something but I feel that the answer to bank resilience is not just a higher capital ratio. A deeper understanding of the pro cyclicality embedded in the system will I think allow us to build a better capital adequacy framework. As yet I don’t see this topic getting the attention it deserves.
Tony – From the Outside
… is the question I reflected on as I read the ECB Report on Banks’ ICAAP Practices (August 2020).
That I should be asking the question is even more curious given the years I spent working with economic capital but there was something in the ECB position that I was not comfortable with. There is nothing particularly wrong in the ways that the ECB envisages that an economic perspective can add value to a bank’s ICAAP. The problem (for me), I came to realise, is more the lack of emphasis on recognising the fundamental limitations of economic models. In short, my concern is that the detailed focus on risk potentially comes at the expense of an equally useful consideration of the ways in which a bank is subject to radical uncertainty.
The rest of this post offers an overview of what the ECB survey observed and some thoughts on the value of explicitly incorporating radical uncertainty into an ICAAP.
The ECB report, based on a survey of 37 significant institutions it supervises, assesses the extent to which these organisations were complying (as at April 2019) with ECB expectations for how the ICAAP should be constructed and executed. The selected sample focuses on the larger (and presumably more sophisticated) banks, including all global systematically important banks supervised by the ECB. I am straying outside my area of expertise (Australian bank capital management) in this post but there is always something to learn from considering another perspective.
The ECB notes that progress has been made in some areas of the ICAAP. In particular; all banks in the survey have risk identification processes in place, they produce summary documents (“Capital Adequacy Statements” in ECB parlance) that enable bank management (not just the technical specialists) to engage with and take responsibility for the capital strength of their bank and the sample banks do incorporate stress testing into their capital planning process.
The ECB believes however that there is still a lot of room for improvement. The general area of concern is that the banks it supervises are still not paying sufficient attention to the question of business continuity. The ECB cites three key areas as being particularly in need of improvement if the ICAAPs are to play their assigned role in effectively contributing to a bank’s continuity:
The value of building the ICAAP on sound data and testing the outcomes of the process under a variety of severe stress scenarios is I think uncontentious.
The value the economic perspective contributes is less black and white. Like many thing in life, the challenge is to get the balance right. My perspective is that economic models are quite useful but they are far from a complete answer and dangerous when they create an illusion of knowledge, certainty and control.
The ECB’s guide to the ICAAP defines the term “economic internal perspective” as follows:
“Under this perspective, the institution’s assessment is expected to cover the full universe of risks that may have a material impact on its capital position from an economic perspective. In order to capture the undisguised economic situation, this perspective is not based on accounting or regulatory provisions. Rather, it should take into account economic value considerations for all economically relevant aspects, including assets, liabilities and risks. …. The institution is expected to manage economic risks and assess them as part of its stress-testing framework and its monitoring and management of capital adequacy”
ECB Guide to the internal capital adequacy assessment process (ICAAP) – Principles, November 2018 (Paragraph 49 / pages 18-19)
So far so good – the key points seem (to me) to be quite fair as statements of principle.
The ECB sees value in looking beyond the accounting and regulatory measures that drive the reported capital ratios (the “normative perspective” in ECB terminology) and wants banks to consider “the full universe of risks that may have a material impact on its capital position”. The ECB Report also emphasises the importance of thinking about capital from a “business continuity” perspective and cites the “… unjustified inclusions of certain capital components (e.g. minority interests, Additional Tier 1 … or Tier 2 … instruments) … which can inflate the internal capital figures” as evidence of banks failing to meet this expectation. Again a fair point in my view.
These are all worthy objectives but I wonder
As a statement of principle, the value of bringing a different perspective to bear clearly has value. The examples that the ECB cites for ways in which the economic perspective can inform and enhance the normative perspective are all perfectly valid and potentially useful. My concern is that the ECB seems to be pursuing an ideal state in which an ICAAP can, with sufficient commitment and resources, achieve a degree of knowledge that enables a bank to control its future.
Business continuity is ultimately founded on a recognition that there are limits to what we can know about the future and I side with the risk philosophy that no amount of analysis will fundamentally change this.
I have touched on the general topic of uncertainty and what it means for the ICAAP a couple of times in this blog. The ECB report mentions “uncertainty” twice; once in the context of assessing climate change risk
Given the uncertainty surrounding the timing of climate change and its negative consequences, as well as the potentially far-reaching impact in breadth and magnitude along several transmission channels via which climate-related risks may impact banks’ capital adequacy, it is rather concerning that almost one-third of the banks has not even considered these risks in their risk identification processes at all.
Page 39
… and then in the context of making allowances for data quality
However, … in an internal deep dive on risk quantification in 2019, half of the risk quantifications showed material deficiencies. This finding is exacerbated by the data quality issues generally observed and moreover by the fact that one-half of the banks does not systematically ensure that the uncertainty surrounding the accuracy of risk quantifications (model risk) is appropriately addressed by an increased level of conservatism.
Page 54
This is not a question of whether we should expect that banks can demonstrate that they are thinking about climate change and making allowances for model risk along with a host of other plausible sources of adverse outcomes. It is a surprise that any relatively large and sophisticated banks might be found wanting in the ways in which these risks are being assessed and the ECB is right to call that out.
However, it is equally surprising (for me at least) that the ECB did not seem to see value in systematically exploring the extent to which the ICAAPs of the banks it supervises deal with the potential for radical uncertainty.
Business continuity is far more likely if banks can also demonstrate that they recognise the limits of what they can know about the future and actively plan to deal with being surprised by the unexpected. In short one of the key ICAAP practices I would be looking for is evidence that banks have explicitly made allowances for the potential for their capital plan to have to navigate and absorb “unknown unknowns”.
For what it is worth, my template for how a bank might make explicit allowances in the ICAAP for unknown unknowns is included in this post on the construction of calibration of cyclical capital buffers. My posts on the broader issue of risk versus uncertainty can be found on the following links:
Feel free to let me know what I am missing …
Tony – From the Outside
Corporate Plans can be pretty dry reading but I had a quick skim of what is on APRA’s agenda for the next four years. The need to deal with consequences of COVID 19 obviously remains front and centre but APRA has reiterated its commitment to pursue the objectives laid out in its previous corporate plan.
Looking outward (what APRA refers to as “community outcomes”) there are four unchanged objectives
Looking inward, APRA’s priorities are:
What I found interesting was a reference in APRA’s four year roadmap for strategy execution to a commitment to “Finalisation of ADI capital regime” (page 26). The schematic provides virtually no detail other than a “Milestone” to be achieved by December 2020 and for the project to be completed sometime in 2022/23.
Based on the outline in the strategic roadmap, my guess is that we will see a consultation paper on capital adequacy released later this year. I don’t have any real insights on exactly what APRA has in mind but a discussion paper APRA released in August 2018 titled “Improving the transparency, comparability and flexibility of the ADI capital framework” may offer some clues.
The DP outlines
“… options to modify the ADI capital framework to improve transparency and comparability of reported capital ratios. The main conceptual approaches APRA is considering and seeking feedback on are:
The First Approach– “Consistent disclosure” – seems to be a beefed up version of the status quo in which APRA gets more directly involved in the comparability process by adding its imprimatur to the internationally harmonised ratios some Australian banks currently choose to disclose as an additional informal measure of capital strength.
“Under this approach, ADIs would continue to determine regulatory capital ratios using APRA’s definitions of capital and RWA. However, APRA would also specify a methodology for ADIs to determine certain adjustments to capital and RWA that could be used for disclosure (Pillar 3) purposes. As noted above, the methodology would focus on aspects of relative conservatism that are material in size and able to be calculated simply and objectively.”
APRA argues that “The supplementary disclosure would allow all stakeholders to better assess the capital strength of an ADI on a more comparable basis. However, it would result in two APRA-endorsed capital ratios: an APRA regulatory capital ratio to be compared against minimum requirements, and an additional disclosure-only capital ratio for, in particular, international comparison.”
A Second Approach – “Capital ratio adjustments” would involve APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and RWA.
The DP explains that this “… alternative approach would involve APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and RWA. This would involve removing certain aspects of relative conservatism from ADIs’ capital ratio calculations and lifting minimum regulatory capital ratio requirements in tandem. This increase in regulatory capital ratio requirements could be in the form of a transparent adjustment to minimum capital ratio requirements—for the purposes of this paper, such an adjustment is termed the ‘APRA Overlay Adjustment’.”
“To maintain overall capital adequacy, the APRA Overlay Adjustment would need to be calculated such that the total dollar amount of Prudential Capital Requirement (PCR) and Capital Conservation Buffer (CCB) would be the same as that required if these measures were not adopted. In other words, the risk-based capital requirements of ADIs would be unchanged in absolute dollar terms, maintaining financial safety, but adjustments to the numerator and the denominator of the capital ratio to be more internationally comparable would increase reported capital ratios.”
APRA clarify that
“These options are not mutually exclusive, and there is potential for both approaches to be adopted and applied in different areas.”
I offered my views on these options here.
Tony – From the Outside
I am currently reading “Thinking in Bets” by Annie Duke. It is early days but I suspect that this is a book that has some useful things to say about creating the kinds of corporate culture that truely reflect the values espoused in corporate mission statements. It is a truth that actions speak louder than words and she cites a practice employed by the American Foreign Service Association which has not one but four awards for employees who have exhibited behaviours that demonstrate initiative, integrity, intellectual courage and constructive dissent.
The attached quote comes from the AFSA website setting out the criteria employed for these awards
Criteria for the Dissent Awards
The awards are for Foreign Service employees who have “exhibited extraordinary accomplishment involving initiative, integrity, intellectual courage and constructive dissent”. The awards publicly recognize individuals who have demonstrated the intellectual courage to challenge the system from within, to question the status quo and take a stand, no matter the sensitivity of the issue or the consequences of their actions. The issue does not have to be related to foreign policy. It can involve a management issue, consular policy, or, in the case of the recently established F. Allen “Tex” Harris Award, the willingness of a Foreign Service Specialist to take an unpopular stand, to go out on a limb, or to stick his/her neck out in a way that involves some risk
… is the title of an interesting post on the Voxeu website summarising some research conducted by a group of European academics.
I have only skimmed the research at this point but the conclusion that realising losses and restructuring banks sets the economy up for stronger growth seem intuitively logical. It is also a timely area of research at a time when there seems to be widespread concern that many so called “zombie” companies are only continuing to operate by virtue of extraordinary levels of liquidity and other financial support being injected into the financial system via central banks.
The post summarises their findings as follows …
Our findings show that restructuring of distressed banks during a crisis has positive long-term effects on productivity. We emphasise the importance of long-term productivity considerations in the design of optimal bank resolution mechanisms. Our results indicate that the challenge is the inherent trade-off between the short- and the long-term effects, which can complicate the political economy of the problem. For instance, in the short term, bailouts can look appealing to government officials, especially if the long-term costs bear less weight in their decision-making processes.
“The cleansing effect of banking crises”- Reint Gropp, Steven Ongena, Jörg Rocholl, Vahid Saadi; Voxeu – 7 August 200
The ability to raise funding via “deposits” is one of the things that makes banks different from other types of companies. As a rule bank deposits benefit from a variety of protections that transform what is effectively an unsecured loan to a highly leveraged company into an (arguably) risk free asset.
This rule is not universal however. The NZ banking system, for example, had (at the time this post was written) a distinctly different approach to bank deposits that not only eschews the protections Australian depositors take for granted but also has the power, via its Open Banking Resolution regime, to write down the value of bank deposits if required to ensure the solvency and viability of a bank. But some form of protection is common.
I previously had a go at the question of “why” bank deposits should be protected here.
This post focuses on the mechanics of “how” AUD denominated deposits held with APRA authorised deposit-taking institutions incorporated in Australia (“Australian ADIs” or “Australian banks”) are protected. In particular, I attempt to rank the relative importance of the various protections built into the Australian system. You may not necessarily agree with my ranking and that is OK – I would welcome feedback on what I may be missing.
Australian bank deposits benefit from multiple layers of protection:
The government guarantee might seem like the obvious candidate for the layer of protection that counts for the most, but I am not so sure. All the layers of protection obviously contribute but my vote goes to deposit preference. The capacity to bail-in the supplementary capital gets an honourable mention. These seem to me to be the two elements that ultimately underwrite the safety of the majority of bank deposits (by value) in Australia.
Intensive supervision clearly helps ensure that banks are well managed and not taking excessive risks but experience demonstrates that it does not guarantee that banks will not make mistakes. The Unquestionably Strong benchmark for CET1 capital developed in response to one of the recommendations of the 2014 Financial System Inquiry also helps but again does not guarantee that banks will not find some new (or not so new) way to blow themselves up.
At face value, the government guarantee seems like it would be all you need to know about the safety of bank deposits (provided you are not dealing with the high quality problem of having more than AUD250,000 in your bank account). When you look at the detail though, the role the government guarantee plays in underwriting the safety of bank deposits seems pretty limited, especially if you hold you deposit account with one of the larger ADIs. The first point to note is that the guarantee will only come into play if a series of conditions are met including that APRA consider that the ADI is insolvent and that the Treasurer determines that it is necessary.
In practice, recourse to the guarantee might be required for a small ADI heavily reliant on deposit funding but I suspect that this chain of events is extremely unlikely to play out for one of the bigger banks. That is partly because the risk of insolvency has been substantially reduced by higher CET1 requirements (for the larger ADI in particular) but also because the government now has a range of tools that allow it to bail-in rather than bail-out certain bank creditors that rank below depositors in the loss hierarchy. There are no great choices when dealing with troubled banks but my guess is that the authorities will choose bail-in over liquidation any time they are dealing with one of the larger ADIs.
Banking systems often seem to evolve in response to specific issues of the day rather than being the result of some grand design. So far as I can tell, it seems that the countries that have chosen not to pursue deposit preference have done so on the grounds that making deposits too safe dilutes market discipline and in the worst case invites moral hazard. That is very clearly the case in the choices that New Zealand has made (see above) and the resources they devote to the disclosure of information regarding the relative risk and strength of their banks.
I understand the theory being applied here and completely agree that market discipline should be encouraged while moral hazard is something to be avoided at all costs. That said, it does not seem reasonable to me to expect that the average bank deposit account holder is capable of making the risk assessments the theory requires, nor the capacity to bear the consequences of getting it wrong.
Bank deposits also function as one of the primary forms of money in most developed economies but need to be insulated from risk if they are to perform this role. Deposit preference not only helps to insulate this component of our money supply from risk, it also tends to transfer the risk to investors (debt and equity) who do have the skills and the capacity to assess and absorb it, thereby encouraging market discipline.
The point I am making here is very similar to the arguments that Grant Turner listed in favour of deposit protection in a paper published in the RBA Bulletin.
There are a number of reasons why authorities may seek to provide greater protection to depositors than to other creditors of banks. First, deposits are a critical part of the financial system because they facilitate economic transactions in a way that wholesale debt does not. Second, they are a primary form of saving for many individuals, losses on which may result in significant adversity for depositors who are unable to protect against this risk. These two characteristics also mean that deposits are typically the main source of funding for banks, especially for smaller institutions with limited access to wholesale funding markets. Third, non-deposit creditors are generally better placed than most depositors to assess and manage risk. Providing equivalent protection arrangements for non-deposit creditors would weaken market discipline and increase moral hazard.
Depositor Protection in Australia, Grant Turner, RBA Bulletin December Quarter 2011 (p45)
For a more technical discussion of these arguments I can recommend a paper by Gary Gorton and George Pennacchi titled “Financial Intermediation and Liquidity Creation” that I wrote about in this post.
I argued above that deposit preference potentially strengthens market discipline by transferring risk to debt and equity investors who have the skills to assess the risk, are paid a risk premium for doing so and, equally as importantly, the capacity to absorb the downside should a bank get into trouble. I recognise of course that this argument is strongest for the larger ADIs which have substantial layers of senior and subordinated debt that help ensure that deposits are materially insulated from bank risk. The capacity to bail-in a layer of this funding, independent of the conventional liquidation process, further adds to the protection of depositors while concentrating the role of market discipline where it belongs.
This market discipline role is one of the chief reasons I think “bail-in” adds to the resilience of the system in ways that higher equity requirements do not. The “skin in the game” these investors have is every bit as real as that the equity investors do, but they have less incentive to tolerate excessive or undisciplined risk taking.
The market discipline argument is less strong for the smaller ADIs which rely on deposits for a greater share of their funding but these entities account for a smaller share of bank deposits and can be liquidated if required with less disruption with the assistance of the government guarantee. The government guarantee seems to be more valuable for these ADIs than it is for the larger ADIs which are subject to a greater level of self-insurance.
Interestingly, the ex ante nature of the funding of the government guarantee means that the ADIs for which it is least valuable (the survivors in general and the larger ADI’s in particular) are also the ones that will be called upon to pay the levy to make good any shortfalls not covered by deposit preference. That is at odds with the principle of risk based pricing that features in the literature about deposit guarantees but arguably a reasonable subsidy that assists the smaller ADIs to compete with larger ADI that have the benefit of risk diversification and economies of scale.
If you want to dig deeper into this question, I have summarised the technical detail of the Australian deposit protection arrangements here. It is a little dated now but I can also recommend the article by Grant Turner published in the RBA Bulletin (December 2011) titled “Depositor Protection in Australia” which I quoted from above.
As always, it is entirely possible that I am missing something – if so let me know.
Tony – From The Outside
The ever reliable Matt Levine discusses the latest stress test results for the US banks. In particular the disconnect between the severity of the assumptions in the hypothetical scenario and the actual results observed to date. He notes that it is still early and plenty of room for the actual outcomes to catch up with the hypothetical. However, one of the issues with stress testing is the way you model the way people (and governments) respond to stress.
As Matt puts it …
But another important answer is that, when a crisis actually happens, people do something about it. They react, and try to make it better. In the case of the coronavirus crisis, the Fed and the U.S. government tried to mitigate the effect of a real disaster on economic and financial conditions. Unemployment is really high, but some of the consequences are mitigated by stimulus payments and increased unemployment benefits. Asset prices fell sharply, but then rose sharply as the Fed backstopped markets. Financing markets seized up, and then the Fed fixed them.
The banks themselves also acted to make things better, at least for themselves. One thing that often happens in a financial crisis is that banks’ trading desks make a killing trading for clients in turbulent markets, which helps to make up for some of the money they lose on bad loans. And in fact many banks had blowout first quarters in their trading divisions: Clients wanted to trade and would pay a lot for liquidity, and banks took their money.
In a hypothetical stress test, you can’t really account for any of this. If you’re a bank, and the Fed asks you to model how you’d handle a huge financial crisis, you can’t really write down “I would simply make a ton of money trading derivatives.” It is too cute, too optimistic. But in reality, lots of banks just went and did that.
Similarly, you obviously can’t write down “I would simply rely on the Fed to backstop asset prices and liquidity.” That is super cheating. Much of the purpose of the stress tests is to make it so the Fed doesn’t have to bail out the banking system; the point is to demonstrate that the banks can survive a financial crisis on their own without government support. But in reality, having a functioning financial system is better than not having that, so the Fed did intervene; keeping people in their homes is better than foreclosing on them, so the government supported incomes. So the banks are doing much better than you might expect with 13.3% unemployment.
So it is likely that the Fed’s stress test is both not harsh enough, in its economic scenario, and too harsh, in its assumption about how that scenario will affect banks.
Notwithstanding the potential for people to respond to and mitigate stress, there is still plenty of room for reality to catch up with and exceed the hypothetical scenario. Back to Matt…
But the fact that the stress test imagines an economic crisis that is much nicer than reality is still a little embarrassing, and the Fed can’t really say “everything is fine even in the terrible downside case of 10% unemployment, the banks are doing great.” So it also produced some new stress-test results (well, not quite a full stress test but a “sensitivity analysis”) assuming various scenarios about the recovery from the Covid crisis (“a rapid V-shaped recovery,” “a slower, more U-shaped recovery,” and “a W-shaped double dip recession”). The banks are much less well capitalized in those scenarios than they are either (1) now or (2) in the original stress tests, though mostly still okay, and the Fed is asking the banks to reconsider stress and capital based on current reality. Also stop share buybacks:
Worth reading
Tony – From the Outside
A BIS paper titled “Green Swan 2 – Climate change and Covid-19: reflections on efficiency versus resilience” initially caught my attention because of the reference to the tension between efficiency versus resilience. This tension is, for me at least, one of the issues that has tended to be ignored in the pursuit of growth and optimised solutions. The papers mainly deal with the challenges that climate change creates for central banks but I think there are also some insights to be drawn on what it means for bank capital management.
A core argument in the paper is that challenges like climate change and pandemics ….
“… require us to rethink the trade-offs between efficiency and resilience of our socio-economic systems … one way to address this issue is to think about buffers or some necessary degree of redundancy for absorbing such large shocks. Countries build FX reserves, banks maintain capital buffers as required by regulators, and so on. Perhaps similar “buffers” could be used in other areas of our societies. For example, could it be time to reassess our production systems, which are meant to be lean and less costly for maximum efficiency?”
The paper draws on a (much longer and more technical) BIS research paper titled “The green swan: Central banking and financial stability in the age of climate change”. Both papers contain the usual caveat that the views expressed do not necessarily reflect those of their respective institutions. With that warning noted, this post draws on both papers to make some observations about what the papers say, and what this means for bank capital management.
There is a lot of content in the combined papers but the points that resonated the most with me were
I am not an expert on climate change modelling, but Chapter 3 of the second paper also has what looks to be a useful overview of the models used to analyse climate change and how the outputs of these models are used to generate economic impacts.
Climate change clearly operates in the domain of radical uncertainty. As such it shares some common elements with “black swan” events; in particular the fact that conventional risk models and analysis are not well suited to measuring and managing the potential adverse impacts. It is equally important however to understand the ways in which climate change differs from a classic black swan event. There is a longer list but the ones that I found most relevant were:
Given the conceptual differences, the authors classify Climate Change as a distinct form which they label a “Green Swan”. To the best of my knowledge, this may be the first time the term has been used in this way. That said, the general point they are making seems to be quite similar to what other authors have labelled as “Grey Rhinos” or “Black Elephants” (the latter an obvious allusion to the “elephant in the room”, a large risk that is visible to everyone but no one wants to address).
The papers distinguish two main channels through which climate change can affect financial stability – physical risks and transition risks.
Physical risks are defined as
… “those risks that arise from the interaction of climate-related hazards […] with the vulnerability of exposure to human and natural systems” (Batten et al (2016)). They represent the economic costs and financial losses due to increasing frequency and severity of climate-related weather events (eg storms, floods or heat waves) and the effects of long-term changes in climate patterns (eg ocean acidification, rising sea levels or changes in precipitation). The losses incurred by firms across different financial portfolios (eg loans, equities, bonds) can make them more fragile.
Transition risks are defined as those
“… associated with the uncertain financial impacts that could result from a rapid low-carbon transition, including policy changes, reputational impacts, technological breakthroughs or limitations, and shifts in market preferences and social norms.
A rapid and ambitious transition to lower emissions, for example, would obviously be desirable from the perspective of addressing climate change but might also mean that a large fraction of proven reserves of fossil fuel cannot be extracted, becoming “stranded assets”. The write down of the value of these assets may have potentially systemic consequences for the financial system. This transition might occur in response to policy changes or by virtue of some technological breakthrough (e.g. problem of generating cheap energy by nuclear fusion is solved).
I started this post with a quote from the first (shorter) paper regarding the way in which the Covid 19 had drawn attention to the extent to which the pursuit of efficiency had made our economies more fragile. The paper explores the ways in which the COVID 19 pandemic exhibits many of the same features that we see in the climate change problem and how the global response to the COVID 19 pandemic might offer some insights into how we should respond to climate change.
The paper is a useful reminder of the nature of the problem but I am less confident that it offers a solution that will work without some form of regulation or public sector investment in the desired level of redundancy. The paper cites bank capital buffers introduced post GFC as an example of what to do but this was a regulated outcome that would most likely not be acceptable for non-financial companies in countries that remain committed to free market ideology.
The Economist published an article on this question that offered numerous examples of similar problems that illustrate the propensity of “humanity, at least as represented by the world’s governments … to ignore them until forced to react” .
Thomas Friedman’s article (“How we broke the world”) is also worth reading on this question …
If recent weeks have shown us anything, it’s that the world is not just flat. It’s fragile.
And we’re the ones who made it that way with our own hands. Just look around. Over the past 20 years, we’ve been steadily removing man-made and natural buffers, redundancies, regulations and norms that provide resilience and protection when big systems — be they ecological, geopolitical or financial — get stressed. We’ve been recklessly removing these buffers out of an obsession with short-term efficiency and growth, or without thinking at all.
The New York Times, 30 May 2020
The second paper, in particular, argues that it is important to improve our understanding of the costs of climate change and to ensure that these costs are incorporated into the prices that drive the resources we allocate to dealing with the challenge (e.g. via a carbon price or tax). However one of its key conclusions is that relying on markets to solve the problem is unlikely to be sufficient even with the help of some form of carbon price that reflects a more complete account of the costs of our current carbon based economy.
In short, the development and improvement of forward-looking risk assessment and climate- related regulation will be essential, but they will not suffice to preserve financial stability in the age of climate change: the deep uncertainty involved and the need for structural transformation of the global socioeconomic system mean that no single model or scenario can provide sufficient information to private and public decision-makers. A corollary is that the integration of climate-related risks into prudential regulation and (to the extent possible) into monetary policy would not suffice to trigger a shift capable of hedging the whole system again against green swan events.
The green swan: Central banking and financial stability in the age of climate change; Chapter 5 (page 66)
Both papers highlight the limitations of trying to measure and understand climate change using conventional probability based risk management tools. The one area they do see as worth pursuing is using scenario based approaches. This makes sense to me but it is also important to distinguish this kind of analysis from the standard stress testing used to help calibrate capital buffers.
The standard application of stress testing takes a severe but plausible macro economic scenario such as a severe recession and determines what are the likely impacts on capital adequacy ratios. This offers a disciplined way of deciding how much capital surplus is required to support the risk appetite choices a bank has made in pursuit of its business objectives.
A simplistic application of climate based stress testing scenarios might take the same approach; i.e. work out how much the scenario impacts the capital and ensure that the buffer is sufficient to absorb the impact. That I think is not the right conclusion and my read of the BIS papers is that they are not advocating that either. The value of the scenario based modelling is to first get a handle on the size of the problem and how exposed the bank is to it. A capital response may be required but the answer may also be to change the nature of your exposure to the risk. That may involve reduced risk limits but it may also involve active participation in collective action to address the underlying problem. A capital management response may be part of the solution but it is far from the first step.
I have only scratched the surface of this topic in this post but the two papers it references are worth reading if you are interested in the question of what climate change, and related Green Swan or Black Elephant problems, mean for the banking system and for central banking. There is a bit more technical detail in the appendix below but it is likely only of interest for people working at the sharp end of trying to measure and manage the problem.
I want to dig deeper into the question of how you use stress testing to assess climate change and related types of risk but that is a topic best left for another post.
Tony – From the outside
Section 3 of the longer paper (“Measuring climate-related risks with scenario-based approaches”) discusses the limitations of the models that are typically used to generate estimates of the ecological and financial impacts of climate change scenarios. There is plenty of material there for climate sceptics but it also assists true believers to understand the limits of what they can actually know and how coming to terms with the radical uncertainty of how climate change plays out shapes the nature of our response.
I have copied some extracts from the chapter below that will give you a flavour of what it has to say. It is pretty technical so be warned …
“… the standard approach to modelling financial risk consisting in extrapolating historical values (eg PD, market prices) is no longer valid in a world that is fundamentally reshaped by climate change (Weitzman (2011), Kunreuther et al (2013)). In other words, green swan events cannot be captured by traditional risk management.
The current situation can be characterised as an “epistemological obstacle” (Bachelard (1938)). The latter refers to how scientific methods and “intellectual habits that were useful and healthy” under certain circumstances, can progressively become problematic and hamper scientific research. Epistemological obstacles do not refer to the difficulty or complexity inherent to the object studied (eg measuring climate-related risks) but to the difficulty related to the need of redefining the problem”
Page 21
nothing less than an epistemological break (Bachelard, 1938) or a “paradigm shift” (Kuhn (1962)) is needed today to overcome this obstacle and more adequately approach climate-relate risks (Pereira da Silva (2019a)).
In fact, precisely an epistemological break may be taking place in the financial sector: recently emerged methodologies aim to assess climate-related risks while relying on the fundamental hypothesis that, given the lack of historical financial data related to climate change and the deep uncertainty involved, new approaches based on the analysis of prospective scenarios are needed. Unlike probabilistic approaches to financial risk management, they seek to set up plausible hypotheses for the future. This can help financial institutions integrate climate-related risks into their strategic and operational procedures (eg for the purpose of asset allocation, credit rating or insurance underwriting) and financial supervisors assess the vulnerability of specific institutions or the financial system as a whole
Climate-economic models and forward-looking risk analysis are important and can still be improved, but they will not suffice to provide all the information required to hedge against “green swan” events.
As a result of these limitations, two main avenues of action have been proposed. We argue that they should be pursued in parallel rather than in an exclusive manner. First, central banks and supervisors could explore different approaches that can better account for the uncertain and nonlinear features of climate-related risks. Three particular research avenues (see Box 5 below) consist in: (i) working with non- equilibrium models; (ii) conducting sensitivity analyses; and (iii) conducting case studies focusing on specific risks and/or transmission channels. Nevertheless, the descriptive and normative power of these alternative approaches remain limited by the sources of deep and radical uncertainty related to climate change discussed above. That is, the catalytic power of scenario-based analysis, even when grounded in approaches such as non-equilibrium models, will not be sufficient to guide decision-making towards a low-carbon transition.
As a result of this, the second avenue from the perspective of maintaining system stability consists in “going beyond models” and in developing more holistic approaches that can better embrace the deep or radical uncertainty of climate change as well as the need for system-wide action (Aglietta and Espagne (2016), Barmes (2019), Chenet et al (2019a), Ryan-Collins (2019), Svartzman et al (2019)).
Pages 42 – 43
Embracing deep or radical uncertainty therefore calls for a second “epistemological break” to shift from a management of risks approach to one that seeks to assure the resilience of complex adaptive systems in the face of such uncertainty (Fath et al (2015), Schoon and van der Leeuw (2015)).38 In this view, the current efforts aimed at measuring, managing and supervising climate-related risks will only make sense if they take place within a much broader evolution involving coordination with monetary and fiscal authorities, as well as broader societal changes such as a better integration of sustainability into financial and economic decision-making.
Page 48
From the outside 