Category: Bank Capital

APRA proposes to simplify the capital adequacy framework by phasing out Additional Tier 1 (AT1)

APRA recently announced that it had concluded that AT1 instruments had not been shown to act effectively in a going concern scenario and were worse than Tier 2 capital in a resolution scenario leaving it with three choices:

  • Maintain the status quo while monitoring to see whether a solution emerged from international developments (either Basel redesigning the instruments or some kind of market solution)
  • Unilaterally redesign AT1 to make it more effective in Australia via some combination of a higher trigger for conversion, a new discretionary trigger and/or restrictions on the investor base
  • Simplify the capital adequacy framework by replacing AT1 with Common Equity Tier 1 (CET1) and/or Tier 2

APRA summarised their conclusion in favour of the “Simplify” option as follows:

“Replacing AT1 with more reliable forms of capital will enable banks to more quickly and confidently use their capital buffers in a crisis scenario and is expected to reduce compliance costs for banks. It will also strengthen the proportionality of the prudential framework by embedding a simpler approach to capital requirements for small and mid-size banks compared to the new requirements for large banks,” Mr Lonsdale said.

Under APRA’s proposed approach:

  • Large, internationally active banks would be able to replace 1.5 per cent AT1 with 1.25 per cent Tier 2 and 0.25 per cent Common Equity Tier 1 (CET1) capital.1
     
  • Smaller banks would be able to fully replace AT1 with Tier 2, with a corresponding reduction in Tier 1 requirements.

One thing we can all agree on is that phasing out AT1 does make the framework simpler, I have questions though:

  1. How does removing AT1 makes it easier to use capital buffers in a crisis?
  2. Does the option to convert to CET1 have no value in a going concern scenario?
  3. Just how risky are these AT1 instruments from an investor perspective?
  4. Will the debt market happily accept the smaller banks switching from AT1 to Tier 2 (i.e. if the debt market and rating agencies do see some value in having AT1 then will the smaller banks be required to hold CET1 instead)?
Does removing AT1 make it easier to use capital buffers in a crisis?

APRA questions whether AT1 discretionary distributions will in fact be cancelled when a bank is under stress and losses are eating into the capital buffers because “… the market signal effects from canceling distributions are considered more detrimental than the minor benefit of additional financial support“,

I don’t disagree that adverse signalling is a concern with any capital management action but I am not sure that this particular example is as big an issue as it is presented to be. This is partly because the dollar value of the AT1 distributions is so small that they don’t really help very much. By all means suspend them at the time that ordinary dividends have been suspended completely but otherwise respect the seniority of these instruments in the capital stack and loss hierarchy.

This brings us to adverse signalling concern that seems to be a significant factor in APRA’s analysis. Clearly you can cut ordinary dividends without the adverse signalling constraint so why is this a problem for AT1 distributions?

  • I suspect the problem is that the seniority of AT1 to CET1 creates the reasonable expectation on the part of AT1 investors that ordinary dividends should be required to do the initial heavy lifting on loss absorption and capital conservation and that AT1 distributions should come into play only when the ordinary dividend is cut to zero
  • APRA itself also acknowledges that the actual financial support created by cancelling the AT1 distributions is “minor” which begs the question why should the A1 distributions be cancelled when the loss absorption and capital conservation requirements can be easily achieved by increasing the reduction in ordinary dividends.
  • Once you get to the point where ordinary dividends are completely cancelled, there is room for AT1 distributions to be cancelled as well without the adverse signalling concern, especially if the bank is reporting losses.

Sometimes this is not the way it has played out. Part of the reason that this logical, predictable hierarchy of loss absorption can be disrupted lies I think with the overly complex way that the Capital Conservation Ratio (CCR) is applied. An explanation of why the CCR is overly complex is a whole topic in itself that I will leave for another day. The people who best understand this point are those working in stress testing who have had to calculate the CCR in a stress scenario (you really have to get into the detail to understand it).

The CCR issue could be addressed by simplifying the way it is calculated and I imagine there would be broad agreement that simplicity is always a desirable feature of any calculation that has to be employed under conditions of stress and uncertainty. The main point I want to make is that “simplifying” the application of the way the CCR is used to conserve capital might be a useful place to start before you decide to get rid of AT1 completely.

The bigger question I think is whether the option to convert AT1 into common equity has no value, either in a going concern scenario or in resolution.

APRA argues that

“Rather than acting to stabilise a bank as a going concern in stress, international experience has shown that AT1 absorbs losses only at a very late stage of a bank failure. … If AT1 was used in Australia APRA considers it would not fulfil its role in stabilising the bank before non-viability was reached.” 

In one sense, late conversion is a feature as opposed to a bug in the design of AT1 instruments. They are designed to convert as a last resort when the 5.125% CET1 Point of Non-Viability is crossed so it should not be a surprise that they convert relatively late in a stressed scenario. Perhaps more importantly the conversion option is calibrated to a point where a bank has run through the standard set of options for conserving and rebuilding capital buffers.

APRA acknowledges that the trigger could be set higher so that conversion happens earlier but asserts that “... this could undermine recovery plan actions and the usability of capital buffers“. So far as I could determine, the only reason cited to support this conclusion is that “A higher trigger, if exercised, may operate as a negative signal to the market at the very time when regulators are aiming to restore confidence“.

The statement regarding market signals is interesting. The conversion trigger, wherever it is set, is something that the “market” is well aware of, so the potential for adverse signalling seems to imply that the situation in the bank is much worse than was commonly understood by the market. If that was not the case then conversion is simply an outcome that the market should have been anticipating. A related concern for APRA is that international experience has shown that banks have failed with CET1 ratios much higher than 5.125 per cent, further reducing the potential value of the PONV trigger in their eyes.

It is obviously true that banking has an unfortunate history of seemingly solvent banks very quickly being found out not to be solvent (or maybe just perceived to be insolvent – much the same thing in practice), let’s call this Scenario 1. This still leaves a lot of other scenarios in which a bank has taken a large hit and just needs an infusion of new common equity to rebuild and survive.

Remember that APRA is proposing to replace 1.5% of AT1 with .25% of CET1 (and 1.25% of T2) for the big banks, while the smaller banks simply swap AT1 for Tier 2. For the bigger banks, the extra 0.25% CET1 arguably makes no real difference to the outcome for a Type 1 scenario, but a bigger block of convertible capital could be useful in the other adverse scenarios. For the smaller banks, they just have less options. So the capital framework proposed by APRA is simpler for sure but it is not obvious that it is better.

A related question is just how risky are these instruments from the investor perspective

The theory is that AT1 should be less risky than common equity because they pay investors a predetermined income distribution and have a more senior position in the loss hierarchy. Clearly we are all comfortable with retail investors holding common equity so in theory it should be ok for them to invest in something less risky.

This nice theoretical framework can get a bit messy in the real world for a couple of reasons:

  • Firstly, the CCR as currently implemented can result in AT1 distributions having to be cut in conjunction with the ordinary dividend thereby disrupting the simple hierarchy in which AT1 only comes into the frame once cutting the ordinary dividend has totally exhausted its capacity to satisfy the CCR
  • Secondly, there have been instances in which loss absorption has been achieved by the write down of the AT1 instrument rather than by conversion to common equity (thereby absorbing loss in a way that benefits common equity at the expense of AT1 investors and violating the loss hierarchy benefits that the AT1 investor though they were paying a premium for.
  • Even if conversion does play out as expected, there remains a risk that the value of the ordinary shares received on conversion continues to fall before the AT1 investors can convert them into cash. Indeed, the simple fact that a block of shares is being issued to investors who are not long term holders can itself contribute to a decline in the share price.

Most of these problems (not all) seem to be fixable:

  • Simplifying the way in which the CCR must be met would help reduce the potential for AT1 distributions to be required to absorb loss sooner than would be expected under the principle that AT1 ranks senior to ordinary equity
  • Similarly, loss absorption at the PONV can also be implemented in ways that respects the hierarchy of loss that AT1 investors believed they had contracted to. I am open to someone making the case that the option to write off AT1 has some value but mostly it just seems to introduce complexity and raise doubts about the seniority of the AT1 instruments.

The potential for AT investors to receive less than par value via the conversion is I think a risk that can’t be eliminated but I am not sure that it need to be eliminated. In the event that the shares received on conversion are sold for less than the conversion price, AT1 investors are still likely to have realised lower losses than those experienced by ordinary shares under the same scenario. Investing at this end of the capital stack is about relative risk and reward, the real question is whether the risk is correctly valued.

It is possible that APRA still concludes that retail investors are unable to accurately assess and price the risks. In that case, you retain the option of restricting the sale of the instruments to sophisticated investors and institutional money. That seems to me like a perfectly reasonable compromise that retains the useful features of these AT1 instruments. I just don’t see that the case has been made to completely eliminate the options that AT1 offers.

Last, but not least, we come to the question of what the debt market thinks about the proposal for smaller banks to completely replace AT1 with T2.and perhaps more importantly what do the rating agencies think?

I have to confess that I don’t know. It does seem to me however that something is being lost. The consultation on the proposal is currently open and more informed minds than my own will I hope be addressing that question in the feedback they offer.

I am speculating here but the only way that I can rationalise the policy option proposed by APRA is that they have concluded that the CET1 levels they have established in response to Unquestionably Strong target set by the 2014 Financial System Inquiry have rendered other forms of “going concern” capital redundant. The rating agencies will clearly have an opinion on this question.

I have been a long way from the front line on these issue for some time but that is my 2 cents worth – as always please let me know what I am missing.

Tony – From the Outside

Japanese housing

At face value the value of Japanese housing might appear a bit off topic for an Australian based banking and finance blog. I believe however that anyone interested in banking probably needs to understand the economics of the housing market in which the banking system operates. Housing affordability is also a recurring topic of debate in Australia without much evidence the problem is being resolved.

With that bit of context, I offer up a post that Noah Smith wrote in response to an essay written by the BBC’s outgoing Tokyo correspondent reflecting on his time in Japan. Noah’s over-riding argument is that Japan is not as stagnant as the BBC correspondent contends. He makes a number of counter arguments but the one that caught my attention is his assessment of the Japanese housing market.

Noah notes that the BBC correspondent opens his article by complaining that Japanese houses tend to depreciate instead of appreciate:

In Japan, houses are like cars.

As soon as you move in, your new home is worth less than what you paid for it and after you’ve finished paying off your mortgage in 40 years, it is worth almost nothing.

It bewildered me when I first moved here as a correspondent for the BBC – 10 years on, as I prepared to leave, it was still the same.

Japan was the future, but it’s stuck in the past

Noah argues that what appears like a problem to someone who is accustomed to expect that house prices should always go up is in fact a strength of the Japanese system …

Weirdly, this is presented as a chronic problem — something Japan should have fixed long ago, but hasn’t. But in reality, depreciating real estate is one of Japan’s biggest strengths. Because Japanese people don’t use their houses as their nest eggs, as they do in much of the West, there is not nearly as much NIMBYism in Japan — people don’t fight tooth and nail to prevent any local development that they worry might reduce their property values, because their property values are going to zero anyway.

As a result, Japanese cities like Tokyo have managed to build enough housing to make housing costs fall, even as people continued to stream from the countryside into the city.

Increased supply is often talked about as a big part of the solution to the housing affordability problem in Australia. Depreciating real estate is clearly not something that the Australian public is going to embrace any time soon (at least not until the political power of renters outweighs home owners) but the Japanese model is interesting none the less if only to see how a society functions under this model.

Tony – From the Outside

Residential mortgage risk weights

I have posted a few times challenging the often repeated assertion that advanced banks are subject to materially lower risk weights than their competitors operating under the standardised approach (see here for example).

I have not seen the argument asserted for some time but APRA has chosen to publish a short note repeating their conclusion that the difference is nowhere near as big as claimed.

Here is a link to the APRA note but the short version is

“APRA estimates that the average pricing differential for housing lending due to differences in IRB and standardised capital requirements is 5 basis points.4 Taking into account the IRRBB capital charge and higher operational costs for IRB banks would further reduce this pricing differential.”

Tony – From the Outside

Deposit insurance under review

Admittedly I only managed a skim read of the FDIC report dated 1 May 2023 on “Options for Deposit Insurance Reform” but I was a bit underwhelmed given the important role deposit insurance plays in the banking system. I think the conclusion that some form of increased but “targeted” coverage makes sense but I was disappointed by the discussion of the consequences for market discipline and moral hazard that might flow from such a move.

The Report considers three options for increasing deposit insurance:

  • Limited Coverage under which the current system would be maintained but the deposit insurance limit might increased above the existing USD250,000 threshold
  • Unlimited Coverage under which all deposits would be fully insured; and
  • Targeted Coverage under which coverage for “business payment accounts” would be substantially increased without significantly changing the limit for other deposits.

The report:

  • Concludes that “Targeted Coverage … is the most promising option to improve financial stability relative to its effect on bank risk-taking, bank funding, and broader markets”
  • But notes there are significant unresolved practical challenges “…including defining accounts for additional coverage and preventing depositors and banks from circumventing differences in coverage”

What I thought was interesting was that the Report seemed to struggle to make up its mind on the role of bank depositors in market discipline. On the one hand the Report states

“Monitoring bank solvency involves fixed costs, making it both impractical and inefficient for small depositors to conduct due diligence. Monitoring banks is also time consuming and requires financial, regulatory, and legal expertise that cannot be expected of small depositors”

Executive Summary, Page 1

… and yet there are repeated references to the ways in which increasing coverage will reduce depositor discipline. The discussion of the pros and cons of Targeted Coverage, for example, states

“The primary drawbacks to providing greater or unlimited coverage to specific account types are the potential loss in depositor discipline and resulting implications for bank-risk taking”

Section6: Options for Increased Deposit Coverage”, Page 58

I am not in favour of unlimited deposit insurance coverage but if you accept that certain types of depositors can’t be expected to monitor bank solvency (and liquidity) then I can’t see the point of saying that reduced depositor discipline is a consequence of changing deposit insurance for these groups or that the “burden” of monitoring is shifted to other stakeholders.

What would have been useful I think is a discussion of which stakeholders are best suited to monitor their bank and apply market discipline. Here again I found the Report disappointing. The Report states “… other creditors and shareholders may continue to play an important role in constraining bank risk-taking …” but does not explore the issue in any real detail.

I also found it confusing that ideas like placing limits on the reliance on uninsured deposits or requirements to increase the level of junior forms of funding (equity and subordinated debt), that were listed as “Potential Complementary Tools” for Limited Coverage and Unlimited Coverage, were not considered relevant in the Targeted Coverage option (See Table 1.1, page 5).

This ties into a broader point about the role of deposit preference. Most discussions about bank deposits focus on regulation, supervision and deposit insurance as the key elements that mitigate the inherent risk that deposits will run. Arguably, the only part of this that depositors understand and care about is the deposit insurance.

I would argue that deposit preference also has an important role to play for two reasons

  • Firstly, it mitigates the cost of deposit insurance by mitigating the risk that assets will be insufficient to cover insured deposits leaving the fund to make good the loss
  • Secondly, it concentrates the debate about market discipline on the junior stakeholders who I believe are best suited to the task of monitoring bank risk taking and exercising market discipline.

I did a post here which discussed the moral hazard question in more depth but the short version is that the best source of market discipline probably lies in the space between senior debt and common equity i.e. Additional Tier 1 and Tier 2 subordinated debt. Common equity clearly has some role to play but the “skin in the game” argument just does not cut it for me. The fact that shareholders benefit from risk taking tends to work against their incentive to provide risk discipline and more capital can have the perverse effect of creating pressure to look for higher returns.

Tony – From the Outside

Small banks …

This post by Cetier on the RBNZ Financial Stability Report poses an interesting question about the future of small banks. He notes that the big banks seem to be doing fine but that small NZ banks are struggling to cover their cost of capital. This disparity between big and small banks also seems to be feature of the Australian banking system. It also looks like big banks in the USA are getting bigger at the expense of the small banks.

There is a perennial question of whether small banks need some support (possibly in the form of less onerous regulation) so that they can offer a source of competition to the larger banks. This is a policy choice that the USA has very deliberately made but it has been argued that this is one of the factors that contributed to the recent spate of bank failures.

This is part of a larger conversation about the tension between competition and financial stability. Marc Rubinstein did a good post on this question which I covered here.

I don’t have any answers but the question is one that I think will get more focus as the US considers its response to the most recent case studies in why banks fail. I don’t have enough expertise on the US Banking system to offer an informed opinion but the Bankers Policy Institute does offer an alternative perspective that argues that the failures were more a question of bad management and lax supervision than of regulation per se. I can say that the risks these US banks were running did seem to clearly violate the principles of Banking 101.

Let me know what I am missing …

Tony – From the Outside

The Secret Diary of a Bank Analyst …

… is the title of a post that Marc Rubinstein dropped this week summarising his perspective on why banks don’t behave like other companies. This is a question I have long been pursuing and I found Marc’s post well worth reading. Marc lists the following factors:

  1. Customer or Creditor
  2. Public or Private
  3. Growth is … not good
  4. Confidence is king
  5. Nobody knows anything

Let’s start with a quick outline of Marc’s observations about why banks don’t behave like other companies.

1) Customer or Creditor?

Marc writes …

“The first thing to understand about banks is that they operate a unique financial structure. Other companies borrow from one group of stakeholders and provide services to another. For banks, these stakeholders are one and the same: their creditors are their customers.”

This is oversimplifying a bit. Banks do also borrow from the bond markets but the key point is that deposits do typically from a large part of a bank’s liability stack and depositors clearly have a customer relationship. Understanding this is fundamental to understanding the business of banking.

2) Public or Private

Marc writes …

“Banks have a licence to create money which confers on them a special status somewhere between private enterprise and public entity. Economists argue that commercial banks create money by making new loans. When a bank makes a loan, it credits the borrower’s bank account with a deposit the size of the loan. At that moment, new money is created.”

He notes that the privilege of creating money comes at the price of being heavily regulated. Getting a banking licence is not easy and once granted banks must comply with a range of capital and liquidity requirements tied to the riskiness of their assets and liabilities. They are also subject to intense oversight of what they do and how they do it.

All of that is pretty well known but Marc makes another observation that may not be so widely understood but is possibly more important because of the uncertainty it injects into the business of banking

“All of this lies in the normal course of business for a bank. What is sometimes overlooked, because it is utilised so infrequently, is the executive power that authorities retain over banks. In some countries, where state owned banks dominate the market, intervention is explicit … But even when a bank is notionally private, the state can exercise direct influence over its operations.”

3) Growth is … not good

Marc writes …

“Most companies thrive on growth. “If you’re not growing, you’re dying,” they say. For investors, growth is a key input in the valuation process. 

But if your job is to create money, growth is not all that hard. And if the cost of generating growth is deferred, because the blowback from mispricing credit isn’t apparent until further down the line, it makes growth even easier to manufacture.”

This certainly resonates with my experience of banking. If you are growing faster than the system as a whole (or aspire to) then you should be asking yourself some hard questions about how you are going to achieve this. Are you really providing superior service or product or are you growing by giving up one or both of margin and credit quality. At the very least, it is important to recognise that growth is often achieved at the expense of Net Interest Margin (NIM) and everyone agrees that a declining NIM is a very big negative for bank valuations.

Marc goes on to observe that …

“The corollary to this is that., unlike in other industries, competition is not necessarily that good either – or at least it comes with a trade-off against financial stability”

Some economists might struggle with this but bank supervisors as a rule can be relied on to chose stability over competition. Marc notes however that US are a possible exception to the general rule …

US authorities are unusually squeamish about the trade-off. Partly, it reflects a respect for private markets but mostly it’s because their smaller banks harness significant lobbying power. …

The US is not necessarily making the wrong choice – its economy is more complex than others and its companies have more diverse financing needs. But it is a choice. As Thomas Sowell said, “There are no solutions. There are only trade-offs.”

4) Confidence is king

The fact that banking is a confidence game is of course no great secret. Marc notes that the problem in part is that confidence in the bank is largely based on proxies for soundness (e.g. capital and liquidity ratios, supervisory oversight, credit ratings) that have a history of being found wanting. So the foundations of confidence in your bank or the banking system as a whole are not themselves entirely reliable. A bank can tick all the boxes but still lose the confidence of the markets and find its viability subject to the (inherently risk averse) judgments of its supervisor and/or central bank.

The problem is exacerbated by the fact that it is difficult if not impossible to restore confidence once it is questioned. Marc restates Bagehot’s classic take on this question …

“If you have to prove you are worthy of credit, your credit is already gone”

Lombard Street: A Description of the Money Market; Walter Bagehot 1873

as follows …

It’s very difficult to restore confidence once it’s gone. One thing not to do is put out a press release saying your liquidity is strong. You’d think people would have learned after Bear Stearns, but no. When the proxies cease to work, saying it ain’t so won’t help either. 

5) Nobody knows anything

Marc writes …

“The dirty secret among bank analysis is that it’s quite hard for an outsider to discern what’s going on inside a bank… It’s only after the the fact it becomes apparent what questions to ask.”

This is probably my personal favourite because I was a bank insider for close to four decades and now I am looking at banks from the outside (hence the name of my blog). I like to think that I learned a bit about banking over that time but mostly what I learned was that banks are really complex beasts and I am still learning new things now. Hats off to anyone who really understands banking without having had the benefit of working on the inside or having the access to talk to people working on the front line of banking.

So what

Marc’s observations accord with my experience so I recommend his post for anyone interested in banking. Banks are one of the core institutions of our economy and our society so understanding them is I think important. Even if you don’t agree with him (and me), his post offers a useful reference point for checking your perspective.

If you want to dig further then there are couple of posts on my blog (see links below) that dig into these questions based in part on my experience but also summarising useful papers and other insights I have come across in the as yet incomplete quest to understand how banks do and should operate.

Tony – From the Outside

Links:

Loss absorption under bail in – watch this space

So much going on in banking; so many lessons and precedents. The way in which Credit Suisse’s Additional Tier 1 securities were applied (and equally as importantly) the way the market reacts is one I think is definitely worth watching.

It was easy to miss this detail given how much has been going on but John Authers (Bloomberg Opinion) neatly sums it up …

Holders of “Additional-Tier 1 (AT-1)” bonds have been wiped out. Credit Suisse’s roughly 16 billion Swiss francs ($17.3 billion) worth of risky notes are now worthless. The deal will trigger a complete writedown of these bonds to increase the new bank’s core capital — meaning that these creditors have had a worse deal than shareholders, who at least now have some stock in UBS.

Bloomberg Opinion “And then there was one”, Points of Return, John Authers 29 March 2023

The relative treatment of shareholders and AT Creditors was, for me at least, a surprise. In the conventional capital stack, shareholders absorb losses before all stakeholders. I did a post here setting out my understanding of loss absorption under bail-in. Christopher Joye helpfully explained that the Swiss seem to do bail in differently …

In contrast to many other bank hybrids, including those issued by Aussie banks, CS bank hybrids cannot, and do not, convert into equity in this scenario (ie, Aussie bank hybrids are converted into equity before a write-off). Instead, the CS hybrids must legally go directly to write-off. They further do not permit any partial write-off: the only option is for the regulator to fully write-off these securities.

“UBS buys Credit Suisse in CHF3 billion deal, bonds fully protected as AT1s are zeroed” Christopher Joye, Livewire 20 March 2023

John Authers offers some more context …

“Additional Tier 1” capital was a category introduced under the Basel III banking accords that followed the GFC, with the intention of providing banks with more security. Holders of the bonds were to be behind other creditors in the event of problems. In the first big test of just how far behind they are, we now know that AT1 bondholders come behind even shareholders.

…. he goes on to note that, while limiting moral hazard requires that someone be at the pointy end of loss absorption, the Swiss precedent poses the big question – who wants to buy Swiss style Additional Tier 1 knowing what they know now …

This follows the logic of the post-crisis approach, and it limits moral hazard. The question is whether anyone will want to hold AT1 bonds after this. The market response will be fascinating, and it remains possible that the regulators have avoided repeating one mistake only to make a new one.

The Swiss logic of favouring shareholders is not obvious to me so maybe I am missing something. It might offer some short term advantage but I am with John Authers on this one. Who signs up for this deal next time. We are definitely living in interesting times.

Tony – From the Outside

“From the Outside” takes stock

This is possibly a bit self indulgent but “From The Outside” is fast approaching the 5th anniversary of its first post so I thought it was time to look back on the ground covered and more importantly what resonated with the people who read what I write.

The blog as originally conceived was intended to explore some big picture questions such as the ways in which banks are different from other companies and the implications this has for thinking about questions like their cost of equity, optimal capital structure, risk appetite, risk culture and the need for prudential regulation. The particular expertise (bias? perspective?) I brought to these questions was that of a bank capital manager, with some experience in the Internal Capital Adequacy Assessment Process (ICAAP) applicable to a large Australian bank and a familiarity with a range of associated issues such as risk measurement (credit, market, operational, interest rate etc), risk appetite, risk culture, funds transfer pricing and economic capital allocation.

Over the close to 5 years that the blog has been operational, something in excess of 200 posts have been published. The readership is pretty limited (196 followers in total) but hopefully that makes you feel special and part of a real in crowd of true believers in the importance of understanding the questions posed above. Page views have continued to grow year on year to reach 9,278 for 2022 with 5,531individual visits.

The most popular post was one titled “Milton Friedman’s doctrine of the social responsibility of business” in which I attempted to summarise Friedman’s famous essay “The Social Responsibility of Business is to Increase its Profits” first published in September 1970. I was of course familiar with Friedman’s doctrine but only second hand via reading what other people said he said and what they thought about their framing of his argument. You can judge for yourself, but my post attempts to simply summarise his doctrine with a minimum of my own commentary. It did not get as much attention but I also did a post flagging what I thought was a reasonably balanced assessment of the pros and cons of Friedman’s argument written by Luigi Zingales.

The second most popular post was one titled “How banks differ from other companies“. This post built on an earlier one titled “Are banks a special kind of company …” which attempted to respond to some of the contra arguments made by Anat Admati and Martin Hellwig. Both posts were based around three distinctive features that I argued make banks different and perhaps “special” …

  • The way in which net new lending by banks can create new bank deposits which in turn are treated as a form of money in the financial system (i.e. one of the unique things banks do is create a form of money);
  • The reality that a large bank cannot be allowed to fail in the conventional way (i.e. bankruptcy followed by reorganisation or liquidation) that other companies and even countries can (and frequently do); and
  • The extent to which bank losses seem to follow a power law distribution and what this means for measuring the expected loss of a bank across the credit cycle.

The third most popular post was titled “What does the “economic perspective” add to can ICAAP“ and this to be frank this was a surprise. I honestly thought no one would read it but what do I know. The post was written in response to a report the European Central Bank (ECB) put out in August 2020 on ICAAP practices it had observed amongst the banks it supervised. What I found surprising in the ECB report was what seemed to me to be an over reliance on what economic capital models could contribute to the ICAAP.

It was not the ECB’s expectation that economic capital should play a role that bothered me but more a seeming lack of awareness of the limitations of these models in providing the kinds of insights the ECB was expecting to see more of and a lack of focus on the broader topic of radical uncertainty and how an ICAAP should respond to a world populated by unknown unknowns. It was pleasing that a related post I did on John Kay and Mervyn King’s book “Radical Uncertainty : Decision Making for an Unknowable Future” also figured highly in reader interest.

Over the past year I have strayed from my area of expertise to explore what is happening in the crypto world. None of my posts have achieved wide readership but that is perfectly OK because I am not a crypto expert. I have been fascinated however by the claims that crypto can and will disrupt the traditional banking model. I have attempted to remain open to the possibility that I am missing something but remain sceptical about the more radical claims the crypto true believers assert. There are a lot of fellow sceptics that I read but if I was going to recommend one article that offers a good overview of the crypto story to date it would be the one by Matt Levine published in the 31 October 2022 edition of Bloomberg Businessweek.

I am hoping to return to my bank capital roots in 2023 to explore the latest instalment of what it means for an Australian bank to be “Unquestionably Strong” but I fear that crypto will continue to feature as well.

Thank you to all who find the blog of interest – as always let me know what I missing.

Tony – From the Outside

After FTX: Explaining the Difference Between Liquidity and Insolvency

Sam Bankman-Fried continues to argue that FTX was solvent. No one is buying this of course but Frances Coppola offers a useful reminder on the difference between illiquidity and insolvency. If you take only one thing away from her article it is to understand the way in which the accounting definition of insolvency can contribute to the confusion.

The confusion between liquidity and solvency is partly caused by the generally accepted definition of “insolvency,” which is “unable to meet obligations as they fall due.” This sounds very much like shortage of cash, i.e., a liquidity crisis. But shortage of cash isn’t necessarily insolvency.

When Frances uses the term “generally accepted) I think she is alluding to Generally Accepted Accounting Principles. I have had the liquidity versus solvency debate more times than I can count and this issue was often the core source of confusion when trying to explain the concepts to people without a Treasury or markets background.

If you want to dig deeper into the solvency versus liquidity question I had a go at the issue here. Matt Levine also had a good column on the topic.

Tony – From the Outside

Predicting phase transitions

I am not sure the modelling methodology described in this article is quite as good as the title suggests…

“Chaos Researchers Can Now Predict Perilous Points of No Return”

… but it would be very interesting if it lives up to the claims made in the article. It is a quick read and the subject matter seems worth keeping an eye on.

Here are two short extracts to give you a flavour of the claims made

A custom-built machine learning algorithm can predict when a complex system is about to switch to a wildly different mode of behavior.

In a series of recent papers, researchers have shown that machine learning algorithms can predict tipping-point transitions in archetypal examples of such “nonstationary” systems, as well as features of their behavior after they’ve tipped. The surprisingly powerful new techniques could one day find applications in climate science, ecology, epidemiology and many other fields.

Tony – From the Outside