Category: Bank Capital

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

Basel III complexity in a picture

The image below is drawn from a post on the Bank Underground blog that explores the extent to which the Basel capital framework has become more complex and harder to read

The overall conclusion (no surprises) is that Basel III is longer and harder to read. Somewhat counterintuitively, the authors conclusion from the image above is that there is one measure where Basel III is simpler compared to Basel II.

Basel II rules need more context than their counterparts with the average node having a chain length of .28 higher than Basel III. Relatedly, the table shows that alterations to rules in Basel III have a smaller knock on effect to rules further down the chain. While Basel III is significantly larger than the previous framework, its network is ‘simpler’, fewer references are made between rules, and chains are on average smaller.

Tony – From the Outside

Bank capital buffers – room for improvement

I recently flagged a speech by Sam Woods (a senior official at the UK Prudential Regulation Authority) which floated some interesting ideas for what he describes as a “radically simpler, radically usable” version of the multi-layered capital buffers currently specified by the BCBS capital accord. At the time I was relying on a short summary of the speech published in the Bank Policy Institute’s “Insights” newsletter. Having now had a chance to read the speech in full I would say that there is a lot to like in what he proposes but also some ideas that I am not so sure about.

Mr Woods starts in the right place with the acknowledgment that “… the capital regime is fiendishly complex”. Complexity is rarely (if ever?) desirable so the obvious question is to identify the elements which can be removed or simplified without compromising the capacity to achieve the underlying economic objectives of the regime.

While the capital regime is fiendishly complex, its underlying economic goals are fairly simple: ensure that the banking sector has enough capital to absorb losses, preserve financial stability and support the economy through stresses.

… my guiding principle has been: any element of the framework that isn’t actually necessary to achieve those underlying goals should be removed. …

With that mind, my simple framework revolves around a single, releasable buffer of common equity, sitting above a low minimum requirement. This would be radically different from the current regime: no Pillar 2 buffers; no CCoBs, CCyBs, O-SII buffer and G-SiB buffers; no more AT1.

In practice, Mr Woods translates this simple design principle into 7 elements:

1. A single capital buffer, calibrated to reflect both microprudential and macroprudential risks.

2. A low minimum capital requirement, to maximise the size of the buffer.

3. A ‘ladder of intervention’ based on judgement for firms who enter their buffer – no mechanical triggers and thresholds.

4. The entire buffer potentially releasable in a stress.

5. All requirements met with common equity.

6. A mix of risk-weighted and leverage-based requirements.

7. Stress testing at the centre of how we set capital levels.

The design elements that appeal to me:
  • The emphasis on the higher capital requirements of Basel III being implemented via buffers rather than via higher minimum ratio thresholds
  • The concept of a “ladder of intervention” with more room for judgment and less reliance on mechanical triggers
  • The role of stress testing in calibrating both the capital buffer but also the risk appetite of the firm
I am not so sure about:
  • relying solely on common equity and “no more AT1” (Additional Tier 1)
  • the extent to which all of the components of the existing buffer framework are wrapped into one buffer and that “entire buffer” is potentially usable in a stress

No more Additional Tier 1?

There is little debate that common equity should be the foundation of any capital requirement. As Mr Woods puts it

Common equity is the quintessential loss-absorbing instrument and is easy to understand.

The problem with Additional Tier 1, he argues, is that these instruments …

… introduce complexity, uncertainty and additional “trigger points” in a stress and so have no place in our stripped-down concept …

I am a huge fan of simplifying things but I think it would be a retrograde step to remove Additional Tier 1 and other “bail-in” style instruments from the capital adequacy framework. This is partly because the “skin in the game” argument for common equity is not as strong or universal as its proponents seem to believe.

The “skin in the game” argument is on solid foundations where an organisation has too little capital and shareholders confronted with a material risk of failure, but limited downside (because they have only a small amount of capital invested), have an incentive to take large risks with uncertain payoffs. That is clearly undesirable but it is not a fair description of the risk reward payoff confronting bank shareholders who have already committed substantial increased common equity in response to the new benchmarks of what it takes to be deemed a strong bank.

I am not sure that any amount of capital will change the kinds of human behaviour that see banks mistakenly take on outsize, failure inducing, risk exposures because they think that they have found some unique new insight into risk or have simply forgotten the lessons of the past. The value add of Additional Tier 1 and similar “bail-in” instruments is that they enable the bank to be recapitalised with a material injection of common equity while imposing a material cost (via dilution) on the shareholders that allowed the failure of risk management to metastasise. The application of this ex post cost as the price of failure is I think likely to be a far more powerful force of market discipline than applying the same amount of capital before the fact to banks both good and bad.

In addition to the potential role AT1 play when banks get into trouble, AT1 investors also have a much greater incentive to monitor (and constrain) excessive risk taking than the common equity holders do because they don’t get any upside from this kind of business activity. AT1 investors obviously do not get the kinds of voting rights that common shareholders do but they do have the power to refuse to provide the funds that banks need to meet their bail-in capital requirements. This veto power is I think vastly underappreciated in the current design of the capital framework.

Keep AT1 but make it simpler

Any efforts at simplification could be more usefully directed to the AT1 instruments themselves. I suspect that some of the complexity can be attributed to efforts to make the instruments look and act like common equity. Far better I think to clearly define their role as one of providing “bail-in” capital to be used only in rare circumstances and for material amounts and define their terms and conditions to meet that simple objective.

There seems, for example, to be an inordinate amount of prudential concern applied to the need to ensure that distributions on these instruments are subject to the same restrictions as common equity when the reality is that the amounts have a relatively immaterial impact on the capital of the bank and that the real value of the instruments lie in the capacity to convert their principal into common equity. For anyone unfamiliar with the way that these instruments facilitate and assign loss absorption under bail-in I had a go at a deeper dive on the topic here.

One buffer to rule them all

I am not an expert on the Bank of England’s application of the Basel capital accord but I for one have always found their Pillar 2B methodology a bit confusing (and I like to think that I do mostly understand capital adequacy). The problem for me is that Pillar 2B seems to be trying to answer much the same question as a well constructed stress testing model applied to calibration of the capital buffer. So eliminating the Pillar 2B element seems like a step towards a simpler, more transparent approach with less potential for duplication and confusion.

I am less convinced that a “single capital buffer” is a good idea but this is not a vote for the status quo. The basic structure of a …

  • base Capital Conservation Buffer (CCB),
  • augmented where necessary to provide an added level of safety for systemically important institutions (either global or domestic), and
  • capped with a variable component designed to absorb the “normal” or “expected” rise and fall of losses associated with the business cycle

… seems sound and intuitive to me.

What I would change is the way that the Countercyclical Capital Conservation Buffer (CCyB) is calibrated. This part of the prudential capital buffer framework has been used too little to date and has tended to be applied in an overly mechanistic fashion. This is where I would embrace Mr Woods’ proposal that stress testing become much more central to the calibration of the CCyB and more explicitly tied to the risk appetite of the entity conducting the process.

I wrote a long post back in 2019 where I set out my thoughts on why every bank needs a cyclical capital buffer. I argued then that using stress testing to calibrate the cyclical component of the target capital structure offered an intuitive way of translating the risk appetite reflected in all the various risk limits into a capital adequacy counterpart. Perhaps more importantly,

  • it offered a way to more clearly define the point where the losses being experienced by the bank transition from expected to unexpected,
  • focussed risk modelling on the parts of the loss distribution that more squarely lay within their “zone of validity”, and
  • potentially allowed the Capital Conservation Buffer (CCB) to more explicitly deal with “unexpected losses” that threatened the viability of the bank.

I have also seen a suggestion by Douglas Elliott (Oliver Wyman) that a portion of the existing CCB be transferred into a larger CCyB which I think is worth considering if we ever get the chance to revisit the way the overall prudential buffers are designed. This makes more sense to me than fiddling with the minimum capital requirement.

As part of this process I would also be inclined to revisit the design of the Capital Conservation Ratio (CCR) applied as CET1 capital falls below specified quartiles of the Capital Conservation Buffer. This is another element of the Basel Capital Accord that is well intentioned (banks should respond to declining capital by retaining an increasing share of their profits) that in practice tends to be much more complicated in practice than it needs to be.

Sadly, explaining exactly why the CCR is problematic as currently implemented would double the word count of this post (and probably still be unintelligible to anyone who has not had to translate the rules into a spreadsheet) so I will leave that question alone for today.

Summing up

Mr Woods has done us all a service by raising the question of whether the capital buffer framework delivered by the Basel Capital Accord could be simplified while improving its capacity to achieve its primary prudential and economic objectives. I don’t agree with all of the elements of the alternative he puts up for discussion but that is not really the point. The important point is to realise that the capital buffer framework we have today is not as useful as it could be and that really matters for helping ensure (as best we can) that we do not find ourselves back in a situation where government finds that bailing out the banks is its least worst option.

I have offered my thoughts on things we could do better but the ball really sits with the Basel Committee to reopen the discussion on this area of the capital adequacy framework. That will not happen until a broader understanding of the problems discussed above emerges so all credit to Mr Woods for attempting to restart that discussion.

As always let me know what I am missing …

Tony – From the Outside

Bank of England official floats “radically usable” buffer for bank capital

I came across this proposal via the Bank Policy Institute’s weekly “Insights” email update

I have not read the speech yet but the summary offered by the BPI suggests that the proposal is worth reviewing in part because it highlights that a key part of the Basel III framework remains a work in progress

Here is the BPI’s summary

Prudential Regulatory Authority chief Sam Woods suggested making the U.K.’s bank capital framework simpler and more flexible. In a speech this week, Woods said regulators should make capital buffers more usable – in other words, entice banks to dip into them to lend during stressful times. The suggested framework, which Woods compared to a concept car and dubbed the “Basel Bufferati,” would be “radically simpler, radically usable, and a million miles away from the current debate but which might prove instructive over the longer term.” It centers on “a single, releasable buffer of common equity, sitting above a low minimum requirement.” It would also replace automatic thresholds with a “ladder of intervention” and feature a mix of risk-weighted and leverage-based requirements. The buffer would be determined using the results of the stress tests that would sit on top of standardized risk weights, which is a concept similar to the current U.S. regime. Therefore, “a lot of the sophistication which currently resides in modelling risk-weights would move into stress testing.”

Tony – From the Outside