Capital Rules Get Less Stressful – Matt Levine

Nice quote from Matt Levine’s opinion piece on the change in US bank capital requirements

Everything in bank capital is controversial so this is controversial. Usually the controversy is that some people want higher capital requirements and other people want lower capital requirements. Here, pleasantly, part of the controversy is about whether this is a higher or lower capital requirement.

https://www.bloomberg.com/opinion/articles/2020-03-05/capital-rules-get-less-stressful

Banks may be asked to absorb more than their contractual share of the economic fallout of the Coronavirus

We have already seen signs that the Australian banks recognise that they need to absorb some of the fallout from the economic impact of the Coronavirus. This commentator writing out of the UK makes an interesting argument on how much extra cost banks and landlords should volunteer to absorb.

Richard Murphy on tax, accounting and political economy
— Read on www.taxresearch.org.uk/Blog/2020/03/04/banks-and-landlords-have-to-pick-up-the-costs-of-the-epidemic-to-come-if-the-the-economy-is-to-have-a-chance-of-surviving/

I am not saying banks should not do this but two themes to reflect on:

1) This can be seen as part of the price of rebuilding trust with the community

2) it reinforces the cyclicality of the risk that bank shareholders are required to absorb which then speaks to what is a fair “Through the Cycle” ROE for that risk

I have long struggled with the “banks are a simple utility ” argument and this reinforces my belief that you need a higher ROE to compensate for this risk

Tony

Dutch Central Bank is proposing to increase mortgage risk weights for Dutch IRB banks in response to elevated macro prudential risks

The European Banking Authority (EBA) published today an Opinion endorsing the decision by Central Bank of the Netherlands (De Nederlandsche Bank – DNB) to modify capital requirements in order to address an increase in macroprudential risk.

These extracts from the EBA press release give you the main facts

This new measure aims at enhancing the resilience of the Dutch banking sector to a potential severe downturn in the residential real estate market against the background of sustained price increases in real estate over the past few years.

In particular, the DNB notified the EBA of its intention to introduce a new macroprudential measure, which consists of a minimum average risk weight floor at the portfolio level based on the loan-to-value (LTV) ratio of the individual loans. More specially, a 12% risk weight is assigned to the portion of the loan not exceeding 55% of the market value of the property that serves to secure the loan, and a 45% risk weight is assigned to the remaining portion of the loan. If the LTV ratio is lower or equal to 55, then a fixed 12% risk weight is assigned to the loan.

In its Opinion, addressed to the Council, the European Commission and the DNB, the EBA acknowledges, in line with the ESRB recommendation on medium-term vulnerabilities in the residential real estate sector in the Netherlands, the concerns on the build-up of risk in this sector, the large proportion of high-LTV loans, high level of indebtedness in Dutch households and the low risk weights for real estate exposures by Dutch IRB banks. In light of this conclusion, the EBA does not object to the deployment, by the DNB, of its proposed macroprudential measure

Possible pitfalls of a 1-in-X approach to financial stability – Bank Underground

Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed are those of the authors, and are not necessarily those of the Bank of England, or its policy committees. Posting on this blog, Adam Brinley Codd and Andrew Gimber argue that false confidence in people’s ability to calculate probabilities of rare events might end up worsening the crises regulators are trying to prevent.

The post concludes with their personal observations about how best to deal with this meta-uncertainty.

Policymakers could avoid talking about probabilities altogether. Instead of a 1-in-X event, the Bank of England’s Annual Cyclical Scenario is described as a “coherent ‘tail risk’ scenario”.

Policymakers could avoid some of the cognitive biases that afflict people’s thinking about low-probability events, by rephrasing low-probability events in terms of less extreme numbers. A “100-year” flood has a 1% chance of happening in any given year, but anyone who lives into their 70s is more likely than not to see one in their lifetime.

Policymakers could  be vocal about the fact that there are worse outcomes beyond the 1-in-X point of the distribution.

— Read on bankunderground.co.uk/2020/02/06/possible-pitfalls-of-a-1-in-x-approach-to-financial-stability/

We don’t want economic growth

We don’t want economic growth https://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2020/01/we-dont-want-economic-growth.html

I think there is a lot of truth in this blog post

– subject to achieving a reasonable minimum, people do seem to care more about relative position than absolute wealth

– the creative destruction associated with growth is good for the herd but the individuals who lose their jobs and can’t find a place in the new economic order are obviously not so keen on the process

– conventional economic policy advice government receives does not really engage with these questions

Relevant extract from the blog copied below

There are, for my purposes, two things are going on here.

One is that what matters for well-being is not so much absolute income as our income relative (pdf) to our peers: if we are doing better than them, we’re happy and if we are doing worse, we’re miserable. Andrew Clark and Andrew Oswald have found that happiness depends more upon relative (pdf) income than absolute income, whilst Christopher Boyce and colleagues have found that it is a person’s position in the income ranking (pdf) that matters for their well-being, not their absolute income**.

If it is relative income we care about, then stagnation shouldn’t trouble us. We have as much chance of getting ahead of our peers when GDP is flatlining as we do when it is growing.

Also, though, economic growth is associated with some things many of us don’t like – with the creative destruction than runs down some industries and areas. As Banerjee and Duflo show in Good Economics for Hard Times, the economy is “sticky”: people do not or cannot adjust to such disruption. Hence Anand Menon’s heckler’s point: “that’s your bloody GDP. Not ours.” A stagnant economy in which zombie firms preserve jobs and in which we face less threat from foreign competition or new technology is perfectly tolerable for many – and better than the tumultuous, threatening growth of the 80s and 90s.

Book recommendations

Doing book recommendations seems to be very on trend. That said, I am a sucker for the “here are my favourite books” tag so here are some of the books I read this year that I can recommend.

“Scale: The Universal Laws of Life and Death in Organisms, Cities and Companies”, by Geoffrey West

The Value of Everything: Making and Taking in the Global Economy”, by Marianna Mazzucato

“The Economist’s Hour: How the False Prophets of Free Markets Fractured Our Society” by Binyamin Appelbaum

“Scale” identifies some universal scaling laws that apply in and across a range of domains, the nature and origin of these systematic scaling laws, how they are all interrelated, and how they lead to a deep and broad understanding of many aspects of life and ultimately to the challenge of global sustainability. The ways in which companies are subject to similar scaling laws to those observed in biological organisms was especially interesting for me but this is just one of a range of topics covered to draw out intriguing insights.

“The Value of Everything” has a particular view on the role of government that you may, or may not, agree with. However even the skeptics who don’t accept her overall thesis would benefit from the primer the writer offers on the different theories of value that have held sway over the formulation of public policy.

Finally, “The Economist’s Hour”. I am only half way through this book but it offered new insights for me on the role of economists and economic theory in driving some pretty fundamental changes in the society we live in.

Tony

Capital geeks take note – the IRB scaling factor strikes again

Capital

Another reminder on the importance of paying attention to the detail courtesy of a story that I picked up reading Matt Levine’s “Money Stuff” column on Bloomberg.

This extract from Matt’s column captures the essential facts:

Here, from Johannes Borgen, is a great little story about bank capital. Yesterday Coventry Building Society, a U.K. bank, announced “a correction to its calculation of risk weighted assets” that will lower its common equity Tier 1 capital ratio from 34.2% to 32.6%. That’s still well over regulatory requirements, so this is not a big deal. But the way Coventry messed up is funny:

“The Society uses Internal Ratings Based (“IRB”) models to calculate its Risk Weighted Assets (“RWAs”) and is seeking to update these models to ensure compliance with upcoming Basel III  reforms. During the process of transitioning models, the Society has identified an omission in connection with its historic calculation of its RWAs. Specifically, the necessary 6% scalar was not applied to the core IRB model outputs. The core IRB models themselves are not impacted.”

For banks that use Internal Ratings Based models, the way the Basel capital rules work is that you apply a complicated formula to calculate the risk weights of your assets, and then at the end of the formula you multiply everything by 1.06. That’s kind of weird. (The Basel capital regime for banks using IRB models “applies a scaling factor in order to broadly maintain the aggregate level of minimum capital requirements, while also providing incentives to adopt the more advanced risk-sensitive approaches.”) It’s weird enough that in the “upcoming Basel III reforms” regulators plan to get rid of it: The 1.06 multiplier is a kludge, and if you measure your risk-weighted assets a bit more accurately and conservatively, you shouldn’t have to multiply them by 1.06 at the end. 

Matt Levine, “Money Stuff”, Bloomberg

For anyone new to this game who wants to dig a bit deeper into how the advanced capital requirements are calculated, the Explanatory Note published by the BCBS in July 2005 is still a good place to start. I published a note on that paper on my blog here. The RBNZ also produced a useful note on how they used the IRB function in the portfolio modelling work they used to support their recent changes to NZ capital requirements.

It should be noted however that none of these documents discuss the 6% scaling factor. I open to alternative perspectives on this but my recollection is that the 6% scaling factor was introduced post July 2005 in one of the multiple recalibration exercises the BCBS employed to ensure that the IRB function did not reduce capital requirements too much relative to the status quo operating under Basel I. It is effectively a “fudge” factor designed to produce a number the BCBS was comfortable with (at that time).

Tony

APRA announces that it will consider a non-zero default level for the counter cyclical capital buffer

The Australian Prudential Regulation Authority (APRA) announced today that it had decided to keep the countercyclical capital buffer (CCyB) for authorised deposit-taking institutions (ADIs) on hold at zero per cent. What was really interesting however is that the information paper also flagged the likelihood of a non-zero default level in the future.

Here is the relevant extract from the APRA media release:

…. the information paper notes that APRA is also giving consideration to introducing a non-zero default level for the CCyB as part of its broader reforms to the ADI capital framework.

APRA Chair Wayne Byres said: “Given current conditions, and the financial strength built up within the banking sector, a zero counter-cyclical buffer remains appropriate.

“However, setting the countercyclical capital buffer’s default position at a non-zero level as part of the ‘unquestionably strong’ framework would not only preserve the resilience of the banking sector, but also provide more flexibility to adjust the buffer in response to material changes in financial stability risks. This is something APRA will consult on as part of the next stage of the capital reforms currently underway.

“Importantly, this would be considered within the capital targets previously announced – it does not reflect any intention to further raise minimum capital requirements.”

“APRA flags setting the countercyclical capital buffer at non-zero level”, APRA media announcement, 11 December 2019

I have argued the case for a non-zero default setting on this buffer in a long form note I published on my blog here, and published some shorter posts on the countercyclical capital buffer here, here and here). One important caveat is is that incorporating a non-zero default for the CCyB does not necessarily means that a bank needs to hold more capital. It is likely to be sufficient to simply partition a set amount of the existing capital surplus. In this regard, it is interesting that APRA has explicitly linked this potential change to the review it it initiated in the August 2018 Discussion Paper on “Improving the transparency, comparability and flexibility of the ADI capital framework”.

I covered that discussion paper in some depth here but one of the options discussed in this paper (“Capital ratio adjustments”) involves APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and Risk Weighted Assets.

Summing up, I would rate this as a positive development but we need to watch how the policy development process plays out.

Tony

The value of having more capital

The debate around the value of having higher capital requirements requires that we understand exactly what the extra capital does and how it reduces the impact of financial crises. Anyone interested in this topic will I think find this post on the Croaking Cassandra blog worth reading. The author is commenting specifically on the recent policy decision by the RBNZ to increase capital requirements but his post can be read as a more general exploration of some of the reasons why a banking system can experience substantial losses and in particular the impact of poor lending practices.

Having established this point , the author then makes the obvious (to me at least) point that capital can help protect bank creditors and ensure that banks can absorb losses and continue to operate but the capital itself cannot do anything to eliminate the costs to the economy of the poor lending itself that created the losses. The capital will help ensure that the impact of the initial losses is not compounded by a freezing up of bank lending but it will not eliminate the adverse GDP impacts of the poor lending that had to be written down or off. That I believe is an important distinction that is often ignored in the bank capital debate.

“Higher bank capital might stop the eventual realisation of the losses falling directly on bank creditors and depositors (that redistributive effect, see above) but it won’t stop the losses themselves (on the bad projects that were funded), it won’t stop those particular markets seizing up and demand no longer being there (no one much wanted to build any more new offices in late 1980s Wellington after the scale of the incipient glut became apparent), it won’t stop people across the economy (lenders, borrowers etc) having to stop and reassess how they think the economy works, their view on what might really be viable projects and so. And they won’t stop the realisation of wealth losses – the wealth that was thought to be there has gone, the only question is who now actually bears the losses.”

The post concludes with a consideration of what the best response should be.

If it really is sustained periods of greatly diminished lending standards that lead to most of the eventual costs the Bank is worrying about, it might be better for the Bank to be focusing more of its energy on understanding bank lending standards and how they are changing, and on understanding and drawing attention to important distortions in the policy or regulatory system that may be misleading borrowers and lenders alike, and so on. I’m not that optimistic that bank regulators can really make that much difference – for various reasons (including their own personal incentives) it is hard to imagine even the best central banks being that influential with governments, or being paid much heed by banks (let alone borrowers and investors not reliant on local credit). But really high capital ratios have a substantial cost to the economy and it just obvious that they are particularly potent as an instrument to limit the sorts of (overstated) costs the Bank worries about. Other big policy distortions, messing up incentives, making it harder to lend or borrow well, might just be one of the messy facts of life. High capital ratios will always appeal to central bankers – when your only tool is a hammer, all problems tend to be interpreted as nails – but they are costly for the economy and whatever gains (beyond the merely redistributive) they offer seem, from experience, likely to be slight.

And what we do need when things go badly wrong, and a whole of reassessment is taking place, is a robustly counter-cyclical monetary policy. The worst costs of serious economic shocks and misperceptions crystallised are around sustained unemployment for the individuals affected. Neither monetary or bank regulatory policy can do much about potential GDP growth or productivity, and they can’t prevent real wealth losses when bad choices have been made in the past, but they can do a great deal to alleviate the adverse cyclical consequences, to keep unemployment as low as possible, consistent with price stability, and deviations from that (unobservable point) as short as possible.

You may not agree with his analysis but the post is worth reading

Tony