Confusing capital and liquidity

I have been planning to write something on the relationship between capital and liquidity for a while. I have postponed however because the topic is complex and not especially well understood and I did not want to contribute to the body of misconceptions surrounding the topic. An article in the APRA Insight publications (2020 Issue One) has prompted me to have a go.

Capital Explained

The article published in APRA’s Insight publication under the title “Capital explained” offers a simple introduction to the question what capital is starting with the observation that …

“Capital is an abstract concept and has different meanings in different contexts.

Capital being abstract and meaning different things in different contexts is a good start but the next sentence troubles me.

“In non-technical contexts, capital is often described as an amount of cash or assets held by a company, or an amount available to invest.”

I am not sure that the author intended to endorse this non-technical description but it was not clear and I don’t think it should be left unchallenged, especially when the casual reader might be inclined to take it at face value. The fact that non-technical descriptions frequently state this is arguably a true statement but the article does not clarify that this description is a source of much confusion and seems to be conflating capital and liquid assets.

The source of the confusion possibly lies in double entry bookkeeping based explanations in which a capital raising will be associated with an influx of cash onto a company balance sheet. What happens next though is that the company has to decide what to do with the cash, it is extremely unlikely that the cash just sits in the company bank account. This is especially true in the case of a bank which has cash flowing into, and out of, the balance sheet every day. The influx of one source of funding (in this case equity) for the bank means that it will most likely choose to not raise some alternate form of funding (debt) on that day. The amount of cash it holds will be primarily driven by the liquidity targets it has set which are related to but in no way the same thing as its capital targets.

Time for me to put up or shut up.

How should we think about the relationship between capital and liquidity including the extent to which holding more liquid assets might, as is sometimes claimed, justify holding less capital.

  • Liquidity risk is mitigated by liquidity management, including holding liquid assets, but this statement offers no insight into the extent to which some residual expected or unexpected aspect of the risk still requires capital coverage (All risks are mitigated to varying extents by management but most still require some level of capital coverage)
  • So the assessment that holding more liquid assets reduces the need to hold capital is open to challenge
  • One of the core functions of capital is to absorb any increase in expenses, liabilities, loan losses or asset write downs associated with or required to resolve an underlying risk issue; the bank may need to recapitalise itself to restore the target level of solvency required to address future issues but the immediate problems are resolved without the consumption of capital compromising solvency
  • Liquid assets, in contrast, buy time to resolve problems but they do not in themselves solve any underlying issues that may be the root cause of the liquidity stress.
  • The relationship between liquidity and solvency is not symmetrical; liquidity is ultimately contingent on a bank being solvent, but a solvent bank can be illiquid.
  • While more liquid assets are not a substitute for holding capital, a more strongly capitalised bank is less likely to be subject to the kinds of liquidity stress events that draw on liquid assets so holding more capital relative to peer banks can reduce liquidity risk
  • Being relatively strong matters in scenarios where uncertainty is high and people resort to simple rules (e.g. withdraw funding from the weakest banks; even if that is not true the risk is that other people express that view and it becomes self-fulfilling)
  • It is important to recognise that the focus of relationship between capital and liquidity risk described above is the capital position relative to peer banks and market expectations, not the absolute stand-alone position
  • The “Unquestionably Strong” benchmark used in the Australian banking system to calibrate the overall target operating range for capital in the ICAAP anchors the bank’s Liquidity Risk appetite setting.
  • Expressed another way, the capital requirements of Liquidity Risk are embedded holistically in the capital buffer the target operating range maintains over prudential minimum capital requirements.

It is entirely possible that I am missing something here – I hope not but let me know if you see an error in my logic

Using machine learning to predict bank distress

Interesting post on the Bank Underground blog by Bank of England staff Joel Suss and Henry Treitel.

This extract summarises their findings

“Our paper makes important contributions, not least of which is practical: bank supervisors can utilise our findings to anticipate firm weaknesses and take appropriate mitigating action ahead of time.

However, the job is not done. For one, we are missing important data which is relevant for anticipating distress. For example, we haven’t included anything that speaks directly to the quality of a firm’s management and governance, nor have we included any information on organisational culture.

Moreover, our period of study only covers 2006 to 2012 – a notoriously rocky time in the banking sector. A wider swathe of data, including both good times and bad, would help us be more confident that our models will perform well in the future.

So while prediction, especially about the future, remains tough, our research demonstrates the ability and improved clarity of machine learning methodologies. Bank supervisors, armed with high-performing and transparent predictive models, are likely to be better prepared to step-in and take action to ensure the safety and soundness of the financial system.”

Probabilities disguising uncertainty

‘In this situation, what you started getting was probabilities that disguised uncertainty as opposed to actually providing you with more useful information.’

Barack Obama commenting on making the decision whether to attack a target which evidence suggested could be Osama Bin Laden

This quote is a drawn from an article that John Kay published on his website under the title “The point of probabilities”. The point he is making is

  • Similar to one touched on in a Bank Underground post that I discussed in a recent post on my blog.
  • Short and worth reading

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