Every bank needs a cyclical capital buffer

This post sets out a case for a bank choosing to incorporate a discretionary Cyclical Buffer (CyB) into its Internal Capital Adequacy Assessment Process (ICAAP). The size of the buffer is a risk appetite choice each individual bank must make. The example I have used to illustrate the idea is calibrated to absorb the expected impact of an economic downturn that is severe but not necessarily a financial crisis style event. My objective is to illustrate the ways in which incorporating a Cyclical Buffer in the target capital structure offers:

  • an intuitive connection between a bank’s aggregate risk appetite and its target capital structure;
  • a means of more clearly defining the point where losses transition from expected to unexpected; and
  • a mechanism that reduces both the pro cyclicality of a risk sensitive capital regime and the tendency for the transition to unexpected losses to trigger a loss of confidence in the bank.

The value of improved clarity, coherence and consistency in the risk appetite settings is I think reasonably self evident. The need for greater clarity in the distinction between expected and unexpected loss perhaps less so. The value of this Cyclical Buffer proposal ultimately depends on its capacity to enhance the resilience of the capital adequacy regime in the face of economic downturns without compromising its risk sensitivity.

There are no absolutes when we deal with what happens under stress but I believe a Cyclical Buffer such as is outlined in this post also has the potential to help mitigate the risk of loss of confidence in the bank when losses are no longer part of what stakeholders expect but have moved into the domain of uncertainty. I am not suggesting that this would solve the problem of financial crisis. I am suggesting that it is a relatively simple enhancement to a bank’s ICAAP that has the potential to make banks more resilient (and transparent) with no obvious downsides.

Capital 101

In Capital 101, we learn that capital is meant to cover “unexpected loss” and that there is a neat division between expected and unexpected loss. The extract below from an early BCBS publication sets out the standard explanation …

Expected and unexpected credit loss

Figure 1 – Expected and Unexpected Loss

The BCBS publication from which this image is sourced explained that

“While it is never possible to know in advance the losses a bank will suffer in a particular year, a bank can forecast the average level of credit losses it can reasonably expect to experience. These losses are referred to as Expected Losses (EL) ….”

One of the functions of bank capital is to provide a buffer to protect a bank’s debt holders against peak losses that exceed expected levels… Losses above expected levels are usually referred to as Unexpected Losses (UL) – institutions know they will occur now and then, but they cannot know in advance their timing or severity….”

“An Explanatory Note on the Basel II IRB Risk Weight Functions” BCBS July 2005

There was a time when the Internal Ratings Based approach, combining some elegant theory and relatively simple math, seemed to have all the answers

  • A simple intuitive division between expected and unexpected loss
  • Allowing expected loss to be quantified and directly covered by risk margins in pricing while the required return on unexpected loss could be assigned to the cost of equity
  • A precise relationship between expected and unexpected loss, defined by the statistical parameters of the assumed loss distribution
  • The capacity to “control” the risk of unexpected loss by applying seemingly unquestionably strong confidence levels (i.e. typically 1:1000 years plus) to the measurement of target capital requirements
  • It even seemed to offer a means of neatly calibrating the capital requirement to the probability of default of your target debt rating (e.g. a AA senior debt rating with a 5bp probability of default = a 99.95% confidence level; QED)

If only it was that simple … but expected loss is still a good place to start

In practice, the inherently cyclical nature of banking means that the line between expected and unexpected loss is not always as simple or clear as represented above. It would be tempting to believe that the transition to expected loan loss accounting will bring greater transparency to this question but I doubt that is the case. Regulatory Expected Loss (REL) is another possible candidate but again I believe it falls short of what would be desirable for drawing the line that signals where we are increasingly likely to have crossed from the domain of the expected to the unexpected.

The problem (from a capital adequacy perspective) with both IFRS9 and REL is that the “expected” value still depends on the state of the credit cycle at the time we are taking its measure. REL incorporates a Downturn measure of Loss Given Default (DLGD) but the other inputs (Probability of Default and Exposure at Default) are average values taken across a cycle, not the values we expect to experience at the peak of the cycle downturn.

We typically don’t know exactly when the credit cycle will turn down, or by how much and how long, but we can reasonably expect that it will turn down at some time in the future. Notwithstanding the “Great Moderation” thesis that gained currency prior to the GFC, the long run of history suggests that it is dangerous to bet against the probability of a severe downturn occurring once every 15 to 25 years. Incorporating a measure into the Internal Capital Adequacy Process (ICAAP) that captures this aspect of expected loss provides a useful reference point and a potential trigger for reviewing why the capital decline has exceeded expectations.

Uncertainty is by definition not measurable

One of the problems with advanced model based approaches like IRB is that banks experience large value losses much more frequently than the models suggest they should. As a consequence, the seemingly high margins of safety implied by 1:1000 year plus confidence levels in the modelling do not appear to live up to their promise.

A better way of dealing with uncertainty

One of the core principles underpinning this proposal is that the boundary between risk (which can be measured with reasonable accuracy) and uncertainty (which can not be measured with any degree of precision) probably lies around the 1:25 year confidence level (what we usually label a “severe recession). I recognise that reasonable people might adopt a more conservative stance arguing that the zone of validity of credit risk models caps out at 1:15 or 1:20 confidence levels but I am reasonably confident that 1:25 defines the upper boundary of where credit risk models tend to find their limits. Each bank can makes its own call on this aspect of risk calibration.

Inside this zone of validity, credit risk models coupled with stress testing and sensitivity analysis can be applied to generate a reasonably useful estimate of expected losses and capital impacts. There is of course no guarantee that the impacts will not exceed the estimate, that is why we have capital. The estimate does however define the rough limits of what we can claim to “know” about our risk profile.

The “expected versus unexpected” distinction is all a bit abstract – why does it matter?

Downturn loss is part of the risk reward equation of banking and manageable, especially if the cost of expected downturn losses has already been built into credit risk spreads. Managing the risk is easier however if a bank’s risk appetite statement has a clear sense of:

  • exactly what kind of expected downturn loss is consistent with the specific types of credit risk exposure the risk appetite otherwise allows (i.e. not just the current exposure but also any higher level of exposure that is consistent with credit risk appetite) and
  • the impact this would be expected to have on capital adequacy.

This type of analysis is done under the general heading of stress testing for both credit risk and capital adequacy but I have not often seen evidence that banks are translating the analysis and insight into a specific buffer assigned the task of absorbing expected downturn losses and the associated negative impact on capital adequacy. The Cyclical Buffer I have outlined in this post offers a means of more closely integrating the credit risk management framework and the Internal Capital Adequacy Assessment Process (ICAAP).

What gets you into trouble …

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so”

Commonly, possibly mistakenly, attributed to Mark Twain

This saying captures an important truth about the financial system. Some degree of volatility is part and parcel of the system but one of the key ingredients in a financial crisis or panic is when participants in the system are suddenly forced to change their view of what is safe and what is not.

This is one of the reasons why I believe that a more transparent framework for tracking the transition from expected to truly unexpected outcomes can add to the resilience of the financial system. Capital declines that have been pre-positioned in the eyes of key stakeholders as part and parcel of the bank risk reward equation are less likely to be a cause for concern or trigger for panic.

The equity and debt markets will still revise their valuations in response but the debt markets will have less reason to question the fundamental soundness of the bank if the capital decline lies within the pre-positioned operating parameters defined by the target cyclical buffer. This will be especially so to the extent that the Capital Conservation Buffer provides substantial layers of additional buffer to absorb the uncertainty and buy time to respond to it.

Calibrating the size of the Cyclical Buffer

Incorporating a Cyclical Buffer does not necessarily mean that a bank needs to hold more capital. It is likely to be sufficient to simply partition a set amount of capital that bank management believes will absorb the expected impact of a cyclical downturn. The remaining buffer capital over minimum requirements exists to absorb the uncertainty and ensure that confidence sensitive liabilities are well insulated from the impacts of that uncertainty.

But first we have to define what we mean by “THE CYCLE”. This is a term frequently employed in the discussion of bank capital requirements but open to a wide range of interpretation.

A useful start to calibrating the size of this cyclical buffer is to distinguish:

  • An economic or business cycle; which seems to be associated with moderate severity, short duration downturns occurring once every 7 to 10 years, and
  • The “financial cycle” (to use a term suggested by Claudio Borio) where we expect to observe downturns of greater severity and duration but lower frequency (say once every 25 years or more).

Every bank makes its own decision on risk appetite but, given these two choices, mine would calibrated to, and hence resilient against, the less frequent but more severe and longer duration downturns associated with the financial cycle.

There is of course another layer of severity associated with a financial crisis. This poses an interesting challenge because it begs the question whether a financial crisis is the result of some extreme external shock or due to failures of risk management that allowed an endogenous build up of risk in the banking system. This kind of loss is I believe the domain of the Capital Conservation Buffer (CCB).

There is no question that banks must be resilient in the face of a financial crisis but my view is that this is a not something that should be considered an expected cost of banking.

Incorporating a cyclical buffer into the capital structure for an Australian D-SIB

Figure 2 below sets out an example of how this might work for an Australian D-SIB that has adopted APRA’s 10.5% CET1 “Unquestionably Strong”: benchmark as the basis of its target capital structure. These banks have a substantial layer of CET1 capital that is nominally surplus to the formal prudential requirements but in practice is not if the bank is to be considered “unquestionably strong” as defined by APRA. The capacity to weather a cyclical downturn might be implicit in the “Unquestionably Strong” benchmark but it is not transparent. In particular, it is not obvious how much CET1 can decline under a cyclical downturn while a bank is still deemed to be “Unquestionably Strong”.

Figure 2 – Incorporating a cyclical buffer into the target capital structure

The proposed Cyclical Buffer sits on top of the Capital Conservation Buffer and would be calibrated to absorb the increase in losses, and associated drawdowns on capital, expected to be experienced in the event of severe economic downturn. Exactly how severe is to some extent a question of risk appetite, unless of course regulators mandate a capital target that delivers a higher level of soundness than the bank would have chosen of its own volition.

In the example laid out in Figure 2, I have drawn the limit of risk appetite at the threshold of the Capital Conservation Buffer. This would be an 8% CET1 ratio for an Australian D-SIB but there is no fundamental reason for drawing the lone on risk appetite at this threshold. Each bank has the choice of tolerating some level of incursion into the CCB (hence the dotted line extension of risk appetite). What matters is to have a clear line beyond which higher losses and lower capital ratios indicate that something truly unexpected is driving the outcomes being observed.

What about the prudential Counter-Cyclical Capital Buffer?

I have deliberately avoided using the term”counter” cyclical in this proposal to distinguish this bank controlled Cyclical Buffer (CyB) from its prudential counterpart, the “Counter Cyclical Buffer” (CCyB), introduced under Basel III. My proposal is similar in concept to the variations on the CCyB being developed by the Bank of England and the Canadian OFSI. The RBNZ is also considering something similar in its review of “What counts as capital?” where it has proposed that the CCyB should have a positive value (indicatively set at 1.5%) at all times except following a financial crisis (see para 105 -112 of the Review Paper for more detail).

My proposal is also differentiated from its prudential counter part by the way in which the calibration of the size of the bank Cyclical Buffer offers a way for credit risk appetite to be more formally integrated with the Internal Capital Adequacy Process (ICAAP) that sets the overall target capital structure.

Summing up

  • Incorporating a Cyclical Buffer into the target capital structure offers a means of more closely integrating the risk exposure and capital adequacy elements of a bank’s risk appetite
  • A breach of the Cyclical Buffer creates a natural trigger point for reviewing whether the unexpected outcomes was due to an unexpectedly large external shock or was the result of credit exposure being riskier than expected or some combination of the two
  • The role of the Capital Conservation Buffer in absorbing the uncertainty associated with risk appetite settings is much clearer if management of cyclical expected loss is assigned to the Cyclical Buffer

What am I missing …

Tony

The “skin in the game” argument for more common equity

One of the traditional arguments for higher common equity requirements is that it increases the shareholders’ “skin in the game” and thereby creates an incentive to be more diligent and conservative in managing risk.

This principle is true up to a point but I believe more common equity mostly generates this desirable risk management incentive when the extra skin in the game (aka capital) is addressing a problem of too little capital. It is much less obvious that more capital promotes more conservative risk appetite for a bank that already has a strong capital position.

In the “too little” capital scenarios, 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.

The European Systemic Risk Board published some interesting research on this question in a paper titled “Has regulatory capital made banks safer? Skin in the game vs moral hazard” . I have copied the abstract below which summarises the key conclusions.

Abstract: The paper evaluates the impact of macroprudential capital regulation on bank capital, risk taking behaviour, and solvency. The identification relies on the policy change in bank-level capital requirements across systemically important banks in Europe. A one percentage point hike in capital requirements leads to an average CET1 capital increase of 13 percent and no evidence of reduction in assets. The increase in capital comes at a cost. The paper documents robust evidence on the existence of substitution effects toward riskier assets. The risk taking behavior is predominantly driven by large and less profitable banks: large wholesale funded banks show less risk taking, and large banks relying on internal ratings based approach successfully disguise their risk taking. In terms of overall impact on solvency, the higher risk taking crowds-out the positive effect of increased capital.

I have only skimmed the paper thus far and have reservations regarding how they measure increased risk. As I understand it, the increased riskiness the analysis measures is based on increases in average risk weights. It was not clear how the analysis distinguished changes in portfolio riskiness from changes in the risk weight measure. That said, the overall conclusions seem intuitively right.

Tony

Australian government support for banks

The impending transition to an increased level of Loss Absorbing Capital has prompted speculation on whether this means that the assumption of government support embedded in the senior debt rating of the large Australian banks remains appropriate. This speculation is fuelled in part by precedents established in the European Union and United States where the implementation of increased loss absorption requirements has resulted in the assessment of government supportiveness being downgraded.

Standard and Poor’s addressed this question in the Australian context and the short answer is that continued high government support is the probable outcome.

“In our view, this framework does not propose–nor have the authorities more broadly taken–any concrete actions that would suggest reduced government support despite the stated intent to reduce the implicit government guarantee and the perception that some banks are too big to fail”

“Australian Government Support For Banks: Will There Be More Twists In The Tale?, 8 April 2019 – S&P Global RatingsDirect

APRA’s proposed framework for increased loss absorption

Before digging into the detail of why S&P continue to believe the Australian Government will most likely remain “highly supportive” of systemically important banks, it will be useful to quickly revisit the discussion paper APRA published in November 2018 setting out its proposed response to the Financial System Inquiry recommendation that the Government “Implement a framework for minimum loss absorbing and recapitalization capacity in line with emerging international practice, sufficient to facilitate the orderly resolution of Australian authorised deposit-taking institutions (ADIs) and minimize taxpayer support”.

APRA proposed that selected Australian banks (mostly D-SIBs) be required to hold more loss absorbing capital via an increase in the minimum Prudential Capital Requirement (PCR) applied the Total Capital Ratio (TCR) they are required to maintain under Para 23 of APS 110.

“The minimum PCRs that an ADI must maintain at all times are:
(a) a Common Equity Tier 1 Capital ratio of 4.5 per cent;
(b) a Tier 1 Capital ratio of 6.0 per cent; and
(c) a Total Capital ratio of 8.0 per cent.
APRA may determine higher PCRs for an ADI and may change an ADI’s PCRs at any time.”

APS 110 Paragraph 23

This means that banks have discretion over what form of capital they use but it is assumed they will choose Tier 2 capital as the lowest cost way to meet the requirement.

A post I did on APRA’s discussion paper, identified 5 issues posed by APRA’s proposed response including the question “To what extent would the public sector continue to stand behind the banking system once the proposed level of self insurance is in place?”. My assessment at that time was that …

“… the solution that APRA has proposed seems to me to give the official family much greater options for dealing with future banking crises without having to call on the taxpayer to underwrite the risk of recapitalising failed or otherwise non-viable banks.

It does not, however, eliminate the need for liquidity support. ... The reality is that banking systems built on mostly illiquid assets will likely face future crises of confidence where the support of the central bank will be necessary to keep the financial wheels of the economy turning. ….

… the current system requires the central bank to be the lender of last resort. That support is extremely valuable and is another design feature that sets banks apart from other companies. It is not the same however, as bailing out a bank via a recapitalisation.

“Does more loss absorption and “orderly resolution” eliminate the TBTF subsidy”, posted on From The Outside (November 2018)

I noted that the proposed increase in loss absorbing capital would give APRA and the RBA much greater options for dealing with the solvency aspect of any future crisis but my main point in that initial response to the policy proposal was that the need for a liquidity support backstop remained. In my experience, solvency and liquidity are frequently conflated in the public discussion of bail-outs and my point was that recognising that they are not the same facilitates a more sensible discussion of the role of bail-in and government support. The steps APRA is proposing to take to reduce the implied level of government support do not change the fact that the central bank standing ready to act as the Lender of Last Resort (“LOLR”) will remain a design feature of the financial system we have, not a bug.

The distinction between solvency an liquidity is important but, with the benefit of hindsight, I should have paid equal attention to the extent to which the Australian government might still be expected to go beyond liquidity support if required and the way in which the Australian approach to bail-in differs from that being developed in the U.S. and the E.U.

Standard and Poors continues to rate the Australian government as “highly supportive”

Notwithstanding some ambiguity introduced by the government’s response to the FSI recommendation, S&P continue to believe that the Australian government will remain “highly supportive” towards the systemically important private sector banks. They clarify that support in this context means “… the propensity of a government to provide extraordinary support (typically a capital injection) …”.

The factors underpinning S&P’s (admittedly subjective) assessment are:

  • The Australian economy’s dependence on continued access to offshore funding via the Australian banks
  • The potential risk of contagion across the four major banks due to their interconnectedness
  • No evidence of in-principle political or social opposition to government support should it prove necessary
  • APRA’s proposed framework for increased loss absorption does not hinder government support (in contrast to the resolution frameworks adopted in the European Union and the United States where bail-in is a pre-requisite for a government funded bail-out)
  • Notwithstanding the broad range of powers that APRA has for dealing with a stressed financial institution, S&P do not see any clearly laid out framework that would allow senior creditors to be captured by a bail-in
  • A track record of prompt and decisive action to support banks where required.

The ambiguity referenced above stems from the Government’s response to the FSI in which it stated that it “… agrees that steps should be taken to reduce any implicit government guarantee and the perception that some banks are too big to fail”.

My prior post referred to APRA’s proposed solution giving “… the official family much greater options for dealing with future banking crises without having to call on the taxpayer…”. The fact that the government will have the option to use pre-positioned capital instruments to recapitalise failing banks in the future does not necessarily mean that they have forgone the option of using public funds, if that is deemed to be a better (or least worst) option. It is also worth noting that the Government’s response itself does not contemplate eliminating the implicit guarantee and the perception that some banks are too big to fail, simply to reducing them.

What would stop the Government using bail-in to recapitalise a bank?

The interesting question here is what would preclude the government from using the bail-in option, choosing instead to use public funds to recapitalise one or more non-viable banks. So long as investors in these instruments bought them with full knowledge of the downside, there is no obvious reason why they should be protected. The bigger issue seems to be whether the banking system can cope with this particular class of investor temporarily choosing to withdraw from funding Australian banks.

Here I think it is important to distinguish between a constraint on access to senior funding and a constraint on access to the kinds of contingent debt/capital instruments used to meet the Total Loss Absorption Requirement. The history of bond defaults suggests that investors eventually forgive or forget but it is also safer to assume that any banking system subject to bail-in might be temporarily excluded from access to the kinds of contingent convertible debt instruments that were used to recapitalise it.

That I suspect is a manageable scenario provided the recapitalisation of the banking system is sufficient to address any concerns that the senior bond holders may have regarding the solvency and/or viability of the banks impacted. Some degree of over-capitalisation of the banks may be necessary to achieve this and the cost of funding can be expected to increase also. This is part of the price of failure. There is however no in principle reason why bail-in of Additional Tier 1, Tier 2 and Tier 3 capital should impact the senior debt so long as it is clear that senior debt is not subject to the same risk of bail-in.

In the absence of access to Additional Tier 1, Tier 2 or Tier 3 capital, these banks will probably be required to temporarily rely on a greater share of common equity to meet their Total Capital Requirement but that can be regenerated through profit retention. I don’t see the capital rebuilding task being materially different to what would have applied if the bank was initially required to meet its TLAC requirement entirely via CET1 capital (as the RBNZ proposes). This is also where the official family can provide liquidity support with minimal risk of the taxpayer facing a loss. Once the bank has regained the trust of the investors, the option of increasing the share of non CET1 capital in the TLAC mix can be re-established.

The importance of the assumption of government support should not be underestimated


This is a complex topic and one where reasonable people can form different interpretations of the facts so let me know if I am missing something …

Table 1 from the S&P report illustrates that an improvement in the Stand Alone Credit Profile (SACP) of one of the Australian majors is not enough on its own to offset a downgrade in S&P’s assessment of government supportiveness. The SACP of the Australian majors is currently assessed at “a-” with government support translating to a 2 notch improvement in the Issuer Credit Rating (ICR) to “AA-“. If the government support assessment is downgraded, the ICR declines 1 notch to “A+” and is not improved even if the SACP is enhanced to “a”.

Tony (From the Outside)

What is the value of information in the money market?

“Debt and institutions dealing with debt have two faces: a quiet one and a tumultuous one …. The shift from an information-insensitive state where liquidity and trust prevails because few questions need to be asked, to an information-sensitive state where there is a loss of confidence and a panic may break out is part of the overall system: the calamity is a consequence of the quiet. This does not mean that one should give up on improving the system. But in making changes, it is important not to let the recent crisis dominate the new designs. The quiet, liquid state is hugely valuable.”

Bengt Holmstrom (2015)

The quote above comes from an interesting paper by Bengt Holmstrom that explores the ways in which the role money markets play in the financial system is fundamentally different from that played by stock markets. That may seem like a statement of the obvious but Holmstrom argues that some reforms of credit markets which based on the importance of transparency and detailed disclosure are misconceived because they do not reflect these fundamental differences in function and mode of operation.

Holmstrom argues that the focus and purpose of stock markets is price discovery for the purpose of allocating risk efficiently. Money markets, in contrast are about obviating the need for price discovery in order to enhance the liquidity of the market. Over-collateralisation is one of the features of the money market that enable deep, liquid trading to occur without the need to understand the underlying risk of the assets that are being funded .

 “The design of money market policies and regulations should recognise that money markets are very different from stock markets. Lessons from the latter rarely apply to the former, because markets for risk-sharing and markets for funding have their own separate logic. The result is two coherent systems with practices that are in almost every respect polar opposites.”


From “Understanding the role of debt in the financial system” Bengt Holmstrom (BIS Working Papers No 479 – January 2015)

Holmstrom appears to have written the paper in response to what he believes are misconceived attempts to reform credit markets in the wake of the recent financial crisis. These reforms have often drawn on insights grounded in our understanding of stock markets where information and transparency are key requirements for efficient price discovery and risk management. His paper presents a perspective on the logic of credit markets and the structure of debt contracts that highlights the information insensitivity of debt. This perspective explains among other things why he believes that information insensitivity is the natural and desired state of the money markets.

Holmstrom notes that one of the puzzles of the GFC was how people traded so many opaque instruments with a seeming ignorance of their real risk. There is a tendency to see this as a conspiracy by bankers to confuse and defraud customers which in turn has prompted calls to make money market instruments more transparent. While transparency and disclosure is essential for risk pricing and allocation, Holmstrom argues that this is not the answer for money markets because they operate on different principles and serve a different function.

 “I will argue that a state of “no questions asked” is the hallmark of money market liquidity; that this is the way money markets are supposed to look when they are functioning well.”

“Among economists, the mistake is to apply to money markets the lessons and logic of stock markets.”

“The key point I want to communicate today is that these two markets are built on two entirely different, one could say diametrically opposite, logics. Ultimately, this is because they serve two very different purposes. Stock markets are in the first instance aimed at sharing and allocating aggregate risk. To do that effectively requires a market that is good at price discovery.

 “But the logic behind transparency in stock markets does not apply to money markets. The purpose of money markets is to provide liquidity for individuals and firms. The cheapest way to do so is by using over-collateralised debt that obviates the need for price discovery. Without the need for price discovery the need for public transparency is much less. Opacity is a natural feature of money markets and can in some instances enhance liquidity, as I will argue later.”

“Why does this matter? It matters because a wrong diagnosis of a problem is a bad starting point for remedies. We have learned quite a bit from this crisis and we will learn more. There are things that need to be fixed. But to minimise the chance of new, perhaps worse mistakes, we need to analyse remedies based on the purpose of liquidity provision. In particular, the very old logic of collateralised debt and the natural, but sometimes surprising implications this has for how information and risk are handled in money markets, need to be properly appreciated.”

There is a section of the paper titled “purposeful opacity” which, if I understood him correctly, seemed to extend his thesis on the value of being able to trade on an “information insensitive” basis to argue that “opacity” in the debt market is something to be embraced rather than eliminated. I struggled with embracing opacity in this way but that in no way diminishes the validity of the distinction he draws between debt and equity markets.

The other useful insight was the way in which over-collateralistion (whether explicit or implicit) anchors the liquidity of the money market. His discussion of why the sudden transition from a state in which the creditworthiness of a money market counter-party is taken for granted to one in which doubt emerges also rings true.

The remainder of this post mostly comprises extracts from the paper that offer more detail on the point I have summarised above. The paper is a technical one but worth the effort for anyone interested in the question of how banks should finance themselves and the role of debt in the financial system.

Money markets versus stock markets

Holmstrom argues that each system displays a coherent internal logic that reflects its purpose but these purposes are in many respects polar opposites.

Stock markets are primarily about risk sharing and price discovery. As a consequence, these markets are sensitive to information and value transparency. Traders are willing to make substantial investments to obtain this information. Liquidity is valuable but equity investors will tend to trade less often and in lower volumes than debt markets.

Money markets, in contrast, Holmstrom argues are primarily about liquidity provision and lending. The price discovery process is much simpler but trading is much higher volume and more urgent.

“The purpose of money markets is to provide liquidity. Money markets trade in debt claims that are backed, explicitly or implicitly, by collateral.

 “People often assume that liquidity requires transparency, but this is a misunderstanding. What is required for liquidity is symmetric information about the payoff of the security that is being traded so that adverse selection does not impair the market. Without symmetric information adverse selection may prevent trade from taking place or in other ways impair the market (Akerlof (1970)).”

“Trading in debt that is sufficiently over-collateralised is a cheap way to avoid adverse selection. When both parties know that there is enough collateral, more precise private information about the collateral becomes irrelevant and will not impair liquidity.”

The main purpose of stock markets is to share and allocate risk … Over time, stock markets have come to serve other objectives too, most notably governance objectives, but the pricing of shares is still firmly based on the cost of systemic risk (or a larger number of factors that cannot be diversified). Discovering the price of systemic risk requires markets to be transparent so that they can aggregate information efficiently.     

Purposeful opacity

“Because debt is information-insensitive … traders have muted incentives to invest in information about debt. This helps to explain why few questions were asked about highly rated debt: the likelihood of default was perceived to be low and the value of private information correspondingly small.”

 Panics: The ill consequences of debt and opacity

“Over-collateralised debt, short debt maturities, reference pricing, coarse ratings, opacity and “symmetric ignorance” all make sense in good times and contribute to the liquidity of money markets. But there is a downside. Everything that adds to liquidity in good times pushes risk into the tail. If the underlying collateral gets impaired and the prevailing trust is broken, the consequences may be cataclysmic”

“The occurrence of panics supports the informational thesis that is being put forward here. Panics always involve debt. Panics happen when information-insensitive debt (or banks) turns into information-sensitive debt … A regime shift occurs from a state where no one feels the need to ask detailed questions, to a state where there is enough uncertainty that some of the investors begin to ask questions about the underlying collateral and others get concerned about the possibility”

These events are cataclysmic precisely because the liquidity of debt rested on over-collateralisation and trust rather than a precise evaluation of values. Investors are suddenly in the position of equity holders looking for information, but without a market for price discovery. Private information becomes relevant, shattering the shared understanding and beliefs on which liquidity rested (see Morris and Shin (2012) for the general mechanism and Goldstein and Pauzner (2005) for an application to bank runs).

Would transparency have helped contain the contagion?

“A strong believer in the informational efficiency of markets would argue that, once trading in credit default swaps (CDS) and then the ABX index began, there was a liquid market in which bets could be made both ways. The market would find the price of systemic risk based on the best available evidence and that would serve as a warning of an imminent crisis. Pricing of specific default swaps might even impose market discipline on the issuers of the underlying debt instruments”

 Shadow banking

 “The rapid growth of shadow banking and the use of complex structured products have been seen as one of the main causes of the financial crisis. It is true that the problems started in the shadow banking system. But before we jump to the conclusion that shadow banking was based on unsound, even shady business practices, it is important to try to understand its remarkable expansion. Wall Street has a hard time surviving on products that provide little economic value. So what drove the demand for the new products?”

 “It is widely believed that the global savings glut played a key role. Money from less developed countries, especially Asia, flowed into the United States, because the US financial system was perceived to be safe … More importantly, the United States had a sophisticated securitisation technology that could activate and make better use of collateral … Unlike the traditional banking system, which kept mortgages on the banks’ books until maturity, funding them with deposits that grew slowly, the shadow banking system was highly scalable. It was designed to manufacture, aggregate and move large amounts of high-quality collateral long distances to reach distant, sizable pools of funds, including funds from abroad.”

“Looking at it in reverse, the shadow banking system had the means to create a lot of “parking space” for foreign money. Securitisation can manufacture large amounts of AAA-rated securities provided there is readily available raw material, that is, assets that one can pool and tranche”

“I am suggesting that it was an efficient transportation network for collateral that was instrumental in meeting the global demand for safe parking space.”

 “The distribution of debt tranches throughout the system, sliced and diced along the way, allowing contingent use of collateral”

“Collateral has been called the cash of shadow banking (European repo council (2014)). It is used to secure large deposits as well as a host of derivative transactions such as credit and interest rate swaps.”  

There is a relatively recent, but rapidly growing, body of theoretical research on financial markets where the role of collateral is explicitly modelled and where the distinction between local and global collateral is important

“Viewed through this theoretical lens, the rise of shadow banking makes perfectly good sense. It expanded in response to the global demand for safe assets. It improved on traditional banking by making collateral contingent on need and allowing it to circulate faster and attract more distant capital. In addition, securitisation created collateral of higher quality (until the crisis, that is) making it more widely acceptable. When the crisis hit, bailouts by the government, which many decry, were inevitable. But as just discussed, the theory supports the view that bailouts were efficient even as an ex ante policy (if one ignores potential moral hazard problems). Exchanging impaired collateral for high-quality government collateral, as has happened in the current crisis (as well as historically with clearing houses), can be rationalised on these grounds.”

 Some policy implications

 A crisis ends only when confidence returns. This requires getting back to the no-questions-asked state ….

Transparency would likely have made the situation worse

“By now, the methods out of a crisis appear relatively well understood. Government funds need to be committed in force (Geithner (2014)). Recapitalisation is the only sensible way out of a crisis. But it is much less clear how the banking system, and especially shadow banking, should be regulated to reduce the chance of crisis in the first place.  The evidence from the past panic suggests that greater transparency may not be that helpful.”

“The logic of over-capitalisation in money markets leads me to believe that higher capital requirements and regular stress tests is the best road for now.”

“Transparency can provide some market discipline and give early warning of trouble for individual banks. But it may also lead to strategic behaviour by management. The question of market discipline is thorny. In good times market discipline is likely to work well. The chance that a bank that is deemed risky would trigger a panic is non-existent and so the bank should pay the price for its imprudence. In bad times the situation is different. The failure of a bank could trigger a panic. In bad times it would seem prudent to be less transparent with the stress tests (for some evidence in support of this dichotomy, see Machiavelli (1532)).”

“On money, debt, trust and central banking”

Is the title of an interesting paper by Claudio Borio (Head of the Monetary and Economic Department at the BIS). This link will take you to the paper but my post offers a short summary of what I took away from it.

Overview of the paper

Borio’s examination of the properties of a well functioning monetary system:

  • stresses the importance of the role trust plays in this system and of the institutions needed to secure that trust.
  • explores in detail the ways in which these institutions help to ensure the price and financial stability that is critical to nurturing and maintaining that trust.
  • focuses not just on money but also the transfer mechanisms to execute payments (i.e. the “monetary system”)

“My focus will be the on the monetary system, defined technically as money plus the transfer mechanisms to execute payments. Logically, it makes little sense to talk about one without the other. But payments have too often been taken for granted in the academic literature, old and new. In the process, we have lost some valuable insights.”

Borio: Page 1

In the process, he addresses several related questions, such as

  • the relationship between money and debt,
  • the viability of cryptocurrencies as money,
  • money neutrality, and
  • the nexus between monetary and financial stability.

Borio highlights three key points he wants you to take away from his paper

First, is the fundamental way in which the monetary system relies on trust and equally importantly the role that institutions, the central bank in particular, play in ensuring there is trust in the system. At the technical level, people need to trust that the object functioning as money will be generally accepted and that payments will be executed but it also requires trust that the system will deliver price and financial stability in the long run.

Second, he draws attention to the “elasticity of credit” (i.e. the extent to which the system allows credit to expand) as a key concept for understanding how the monetary system works. It is well understood that allowing too much credit expansion can cause serious economic damage in the long run but elasticity of credit, he argues, is essential for the day to day operations of the payment system.

Third, the need to understand the ways in which price and financial stability are different but inexorably linked. As concepts, they are joined at the hip: both embody the trust that sustains the monetary system. But the underlying processes required to achieve these outcomes differ, so that there can be material tensions in the short run.

These are not necessarily new insights to anyone who has being paying attention to the questions Borio poses above, but the paper does offer a good, relatively short, overview of the issues.

I particularly liked the way Borio

  • presented the role elasticity of credit plays in both the short and long term functioning of the economy and how the tension between the short and long term is managed,
  • covered the relationship between money, debt and trust (“we can think of money as an especially trustworthy type of debt”), and
  • outlined how and why the monetary system should be seen, not as an “outer facade” but rather as a “cornerstone of an economy”

The rest of this post contains more detailed notes on some, but not all, of the issues covered in the paper.

Elements of a well functioning monetary system

The standard definition of money is based on its functions as
1) Unit of account
2) Means of payment
3) Store of value

Borio expands the focus to encompass the “monetary system”as a whole, introducing two additional elements. Firstly the need to consider the mechanisms the system uses to transfer the means of payment and settle transactions. Secondly, the ways in which the integrity of the chosen form of money as a store of value is protected.

” In addition, compared with the traditional focus on money as an object, the definition crucially extends the analysis to the payment mechanisms. In the literature, there has been a tendency to abstract from them and assume they operate smoothly in the background. I believe this is one reason why money is often said to be a convention …. But money is much more than a convention; it is a social institution (eg Giannini (2011)). It is far from self-sustaining. Society needs an institutional infrastructure to ensure that money is widely accepted, transactions take place, contracts are fulfilled and, above all, agents can count on that happening”

Borio: Page 3

The day to day operation of the monetary system

Borio highlights two aspects of the day to day operations of the monetary system.

  1. The need for an elastic supply of the means of payment
  2. The need for an elastic supply of bank money more generally

In highlighting the importance of the elasticity of credit, he also draws attention to “the risk of overestimating the distinction between credit (debt) and money”.

The central banks’ elastic supply of the means of payment is essential to ensure that (i) transactions are settled in the interbank market and (ii) the interest rate is controlled.

“To smooth out interbank settlement, the provision of central bank credit is key. The need for an elastic supply to settle transactions is most visible in the huge amounts of intraday credit central banks supply to support real-time gross settlement systems – a key way of managing risks in those systems (Borio (1995)).”

Borio: Page 5
“…we can think of money as an especially trustworthy type of debt”

Put differently, we can think of money as an especially trustworthy type of debt. In the case of bank deposits, trust is supported by central bank liquidity, including as lender of last resort, by the regulatory and supervisory framework and varieties of deposit insurance; in that of central bank reserves and cash, by the sovereign’s power to tax; and in both cases, by legal arrangements, way beyond legal tender laws, and enshrined in market practice.

Borio: Page 9

Once you understand the extent to which our system of money depends on credit relationship you understand the extent to which trust is a core feature which should not be taken for granted. The users of the monetary system are relying on some implied promises that underpin their trust in it.

“Price and financial instability amount to broken promises.”

Borio: Page 11

While the elasticity of money creation oils the wheels of the payment system on a day to day basis, it can be problematic over long run scenarios where too much elasticity can lead to financial instability. Some degree of elasticity is important to keep the wheels of the economy turning but too much can be a problem because the marginal credit growth starts to be used for less productive or outright speculative investment.

The relationship between price and financial stability

While, as concepts, price and financial stability are joined at the hip, the processes behind the two differ. Let’s look at this issue more closely


The process underpinning financial instability hinges on how “elastic” the monetary system is over longer horizons, way beyond its day-to-day operation. Inside credit creation is critical. At the heart of the process is the nexus between credit creation, risk-taking and asset prices, which interact in a self-reinforcing fashion generating possibly disruptive financial cycles (eg Borio (2014)). The challenge is to ensure that the system is not excessively elastic drawing on two monetary system anchors. One operates on prices – the interest rate and the central bank’s reaction function … The other operates on quantities: bank regulatory requirements, such as those on capital or liquidity, and the supervisory apparatus that enforces them.

Borio: Page 12

Given that the processes underlying price and financial stability differ, it is not surprising that there may be material tensions between the two objectives, at least in the near term. Indeed, since the early 1980s changes in the monetary system have arguably exacerbated such tensions by increasing the monetary system’s elasticity (eg Borio (2014)). This is so despite the undoubted benefits of these changes for the world economy. On the one hand, absent a sufficiently strong regulatory and supervisory apparatus – one of the two anchors – financial liberalisation, notably for banks, has provided more scope for outsize financial cycles. On the other hand, the establishment of successful monetary policy frameworks focused on near-term inflation control has meant that there was little reason to raise interest rates – the second anchor – since financial booms took hold as long as inflation remained subdued. And in the background, with the globalisation of the real side of the economy putting persistent downward pressure on inflation while at the same time raising growth expectations, there was fertile ground for financial imbalances to take root in.

Borio: Page 16

Borio concludes that the monetary system we have is far from perfect but it is better than the alternatives

Borio concludes that the status quo, while far from perfect, is worth persisting with. He rejects the cryptocurrency path but does not explicitly discuss other radical options such as the one proposed by Mervyn King, in his book “The End of Alchemy”. The fact that he believes “… the distinction between money and debt is often overplayed” could be interpreted as an indirect rejection of the variations on the Chicago Plan that have recently reentered public debate. It would have been interesting to see him address these alternative monetary system models more directly.

In Borio’s own words ….

The monetary system is the cornerstone of an economy. Not an outer facade, but its very foundation. The system hinges on trust. It cannot survive without it, just as we cannot survive without the oxygen we breathe. Building trust to ensure the system functions well is a daunting challenge. It requires sound and robust institutions. Lasting price and financial stability are the ultimate prize. The two concepts are inextricably linked, but because the underlying processes differ, in practice price and financial stability have often been more like uncomfortable bedfellows than perfect partners. The history of our monetary system is the history of the quest for that elusive prize. It is a journey with an uncertain destination. It takes time to gain trust, but a mere instant to lose it. The present system has central banks and a regulatory/supervisory apparatus at its core. It is by no means perfect. It can and must be improved.55 But cryptocurrencies, with their promise of fully decentralised trust, are not the answer.

Paraphrasing Churchill’s famous line about democracy, “the current monetary system is the worst, except for all those others that have been tried from time to time”.

Page 18

The topic is not for everyone, but I found the paper well worth reading.

Tony

The Bankers’ New Clothes: Arguments for simpler capital and much reduced leverage

It always pays to make sure you expose yourself to the opposite view. This post looks at some of the arguments for simpler and higher bank capital requirements put forward by Professors Admati and Hellwig. They have published a number of papers and a book on the topic but this post refers chiefly to their book “The Bankers’ New Clothes” and to a paper ‘The Parade of the Banker’s New Clothes Continues: 31 Flawed Claims Debunked”. As I understand it, the key elements of their argument are that:

  • Banks are inherently risky businesses,
  • Excessive borrowing by banks increases their inherent riskiness, but
  • Banks are only able to maintain this excessive level of borrowing because
    • Flawed risk based capital models underestimate the true capital requirements of the business
    • Market discipline also allows excessive borrowing because it is assumed that the government will bail out banks if the situation turns out badly

They identify a variety of ways of dealing with the problem of excessive leverage (controls on bank lending, liquidity requirements and capital requirements) but argue that substantially more common equity is the best solution because:

  • It directly reduces the probability that a bank will fail (i.e. all other things being equal, more common equity reduces the risk of insolvency),
  • A higher level of solvency protection has the added benefit of also reducing the risk of illiquidity, and
  • Contrary to claims by the banking industry, there is no net cost to society in holding more common equity because the dilution in ROE will be offset by a decline in the required return on equity

They concede that there will be some cost associated with unwinding the Too Big To Fail (TBTF) benefit that large banks currently enjoy on both the amount banks can borrow and on the cost of that funding but argue there is still no net cost to society in unwinding this undeserved subsidy. The book, in particular, gets glowing reviews for offering a compelling case for requiring banks to operate with much lower levels of leverage and for pointing out the folly of risk based capital requirements.

There are a number of areas where I find myself in agreement with the points they argue but I can’t make the leap to accept their conclusion that much a higher capital requirement based on a simple leverage ratio calculation is the best solution. I have written this post to help me think through the challenges they offer my beliefs about how banks should be capitalised.

It is useful, I think, to first set out the areas where we (well me at least) might agree in principle with what they say; i.e.

  • Financial crises clearly do impose significant costs on society and excessive borrowing does tend to make a financial system fragile (the trick is to agree what is “excessive”)
  • Better regulation and supervision have a role to play in minimising the risk of bank failure (i.e. market discipline alone is probably not enough)
  • Public policy should consider all costs, not just those of the banking industry
  • All balance sheets embody a trade-off between enterprise risk, return and leverage (i.e. increasing leverage does increase risk)

It is less clear however that:

  • The economics of bank financing are subject to exactly the same rules as that which apply to non-financial companies (i.e. rather than asserting that banks should be compared with non-financial companies, it is important to understand how banks are different)
  • A policy of zero failure for banks is necessarily the right one, or indeed even achievable (i.e. would it be better to engineer ways in which banks can fail without dragging the economy down with them)
  • Fail safe mechanisms, such as the bail in of pre-positioned liabilities, have no prospect of working as intended
  • The assertion that “most” of the new regulation intended to make banks safer and easier to resolve has been “rejected, diluted or delayed” is a valid assessment of what has actually happened under Basel III
  • That liquidity events requiring lender of last resort support from the central bank are always a solvency problem

Drawing on some previous posts dealing with these issues (see here, here and here), I propose to focus on the following questions:

  • How does the cost of bank financing respond to changes in leverage?
  • Are the risk based capital requirements as fundamentally flawed as the authors claim?
  • Are risk management incentives for bankers always better when they are required to hold increasing levels of common equity?
  • Do the increased loss absorption features of Basel III compliant hybrids (in particular, the power to trigger conversion or bail in of the instruments) offer a way to impose losses on failed banks without disrupting the economy or requiring public support

How does leverage affect the cost of bank financing?

Increasing the proportion of equity funding, the authors argue, reduces the risk that shareholders are exposed to because each dollar of equity they have invested

“ will be affected less intensely by the uncertainty associated with the investments”

“when shareholders bear less risk per dollar invested, the rate of return they require is lower”

“Therefore, taking the costs of equity as fixed and independent of the mix of equity and debt involves a fundamental fallacy”.

Banker’sNew Clothes (p101)

The basic facts they set out are not really contentious; the mix of debt and equity does impact required returns. The authors focus on what happens to common equity but changing leverage impacts both debt and equity. This is very clear in the way that rating agencies consider all of the points nominated by the authors when assigning a debt rating. Reduced equity funding will likely lead to a decline in the senior and subordinated debt ratings and higher costs (plus reduced access to funding in absolute dollar terms) while higher equity will be a positive rating factor.

Banks are not immune to these fundamental laws but it is still useful to understand how the outcomes are shaped by the special features of a bank balance sheet. My views here incorporate two of the claims they “debunk” in their paper; specifically

Flawed Claim #4: The key insights from corporate finance about the economics of funding, including those of Modigliani and Miller, are not relevant for banks because banks are different from other companies

Flawed Claim #5: Banks are special because they create money

One of the features that defines a bank is the ability to take deposits. The cost of deposits however tends to be insulated from the effects of leverage. This is a design feature. Bank deposits are a major component of the money supply but need to be insensitive to adverse information about the issuing bank to function as money.

Wanting bank deposits to be information insensitive does not make them so. That is a function of their super senior position in the liability loss hierarchy, supplemented in many, if not most, banking systems by some form of limited deposit insurance (1). I credit a paper by Gary Gorton and George Pennacchi titled “Financial Intermediaries and Liquidity Creation” for crytalising this insight (an earlier post offers a short summary of that paper). Another paper titled “Why Bail-In? And How?” by Joseph Sommer proposes a different rationale for deposits having a super senior position insulated from the risk of insolvency but the implications for the impact of leverage on bank financing costs are much the same.

A large bank also relies on senior unsecured financing. This class of funding is more risky than deposits but still typically investment grade. This again is a design feature. Large banks target an investment grade rating in order to deliver, not only competitive financing costs, but equally (and perhaps more importantly) access to a larger pool of potential funding over a wider range of tenors. The investment grade rating depends of course on there being sufficient loss absorbing capital underwriting that outcome. There is no escaping this law of corporate finance. 

The debt rating of large banks is of course also tied up with the issue of banks being treated as Too Big To Fail (TBTF). That is a distortion in the market that needs to be addressed and the answer broadly is more capital though the rating agencies are reasonably agnostic on the form this capital should take in so far as the senior debt rating is concerned. Subject to having enough common equity anchoring the capital structure, more Tier 2 subordinated debt (or Tier 3 bail-in) will work just as well as more common equity for the purposes of reducing the value of implied government support currently embedded in the long term senior debt rating.

Admati and Hellwig are right – there is no free lunch in corporate finance

At this stage, all of this risk has to go somewhere. On that point I completely agree with Admati and Hellwig. There is no free lunch, the rating/risk of the senior tranches of financing depend on having enough of the right kinds of loss absorbing capital standing before them in the loss hierarchy. Where I part company is on the questions of how much capital is enough and what form it should take.

How much capital is (more than) enough?

Admati and Hellwig’s argument for more bank capital has two legs. Firstly, they note that banks are typically much more leveraged than industrial companies and question how can this be given the fundamental law of capital irrelevancy defined by Modigliani and Miller. Secondly, they argue that risk based capital requirements are fundamentally flawed and systematically under estimate how much capital is required.

Why are banks different?

Admati and Hellwig note that banks have less capital than industrial companies and conclude that this must be a result of the market relying on the assumption that banks will be bailed out. The existence of a government support uplift in the senior debt ratings of large banks is I think beyond debate. There is also broad support (even amongst many bankers) that this is not sound public policy and should ideally be unwound.

It is not obvious however that this wholly explains the difference in observed leverage. Rating agency models are relatively transparent in this regard (S&P in particular) and the additional capital required to achieve a rating uplift equivalent to the existing government support factor would still see banks more leveraged than the typical industrial company. Bank balance sheets do seem to be different from those of industrial companies.

Flawed risk models

The other leg to their argument is that risk based capital fundamentally under estimates capital requirements. I am broadly sympathetic to the sceptical view on how to use the outputs of risk models and have been for some time. An article I wrote in 2008, for example, challenged the convention of using a probability of default associated with the target debt rating to precisely calibrate the amount of capital a bank required.

The same basic concept of highly precise, high confidence level capital requirements is embedded in the Internal Ratings Based formula and was part of the reason the model results were misinterpreted and misused. Too many people assigned a degree of precision to the models that was not warranted. That does not mean however that risk models are totally useless.

Professors Admati and Hellwig use simple examples (e.g. how does the risk of loss increase if a personal borrower increases leverage on a home loan) to argue that banks need to hold more capital. While the basic principle is correct (all other things equal, leverage does increase risk), the authors’ discussion does not draw much (or possibly any?) attention to the way that requiring a borrower to have equity to support their borrowing reduces a bank’s exposure to movements in the value of the loan collateral.

In the examples presented, any decline in the value of the assets being financed flows through directly to the value of equity, with the inference that this would be true of a bank also. In practice, low risk weights assigned by banks to certain (low default – well secured) pools of lending reflect the existence of borrower’s equity that will absorb the first loss before the value of the loan itself is called into question.

A capital requirement for residential mortgages (typically one of the lowest risk weights and also most significant asset classes) that looks way too low when you note that house prices can easily decline by 10 or 20%, starts to make more sense when you recognise that that there is (or should be) a substantial pool of borrower equity taking the brunt of the initial decline in the value of collateral. The diversity of borrowers is also an important factor in reducing the credit risk of the exposures (though not necessarily the systemic risk of an overall meltdown in the economy). Where that is not the case (and hence the renewed focus on credit origination standards and macro prudential policy in general), then low risk weights are not justified.

I recognise that this argument (incorporating the value of the borrower’s equity) does not work for traded assets where the mark to market change in the value of the asset flows directly to the bank’s equity. It does however work for the kinds of assets on bank balance sheets that typically have very low risk weights (i.e. the primary concern of the leverage ratio advocates). It also does not preclude erring on the side of caution when calculating risk weights so long as the model respects the relative riskiness of the various assets impacting the value of equity.

How much also depends on the quality of risk management (and supervision)

The discussion of how much capital a bank requires should also recognise the distinction between how much a well managed bank needs and how much a poorly managed bank needs. In a sense, the authors are proposing that all banks, good and bad, should be made to hold the capital required by bad banks. Their focus on highlighting the risks of banking obscures the fact that prudent banking mitigates the downside and that well managed banks are not necessarily consigned to the extremes of risk the authors present as the norm of banking.

While not expressed in exactly that way, the distinction I am drawing is implicit in Basel III’s Total Loss Absorbing Capital (TLAC) requirements now being put in place. TLAC adds a substantial layer of additional loss absorption on top of already substantially strengthened common equity requirements. The base layer of capital can be thought of as what is required for a well managed, well supervised bank with a sound balance sheet and business model. APRA’s “Unquestionably Strong” benchmark for CET1 is a practical example of what this requirement looks like. The problem of course is that all banks argue they are good banks but the risk remains that they are in fact bad banks and we usually don’t find out the difference until it is too late. The higher TLAC requirement provides for this contingency.

What should count as capital?

I looked at this question in a recent post on the RBNZ’s proposal that virtually all of their TLAC requirement should be comprised of common equity. Admati and Hellwig side with the RBNZ but I believe that a mix of common equity and bail-in capital (along the lines proposed by APRA) is the better solution.

Read my earlier post for the long version, but the essence of my argument is that bail-in capital introduces a better discipline over bank management risk appetite than does holding more common equity. Calibrating common equity requirements to very high standards should always be the foundation of a bank capital structure. Capital buffers in particular should be calibrated to withstand very severe external shocks and to be resilient against some slippage in risk management.

The argument that shareholders’ need to have more “skin in the game” is very valid where the company is undercapitalised. Bail-in capital is not a substitute for getting the basics right. A bank that holds too little common equity, calibrated to an idealised view of both its own capabilities and of the capacity of the external environment to surprise the modellers, will likely find itself suppressing information that does not fit the model. Loss aversion then kicks in and management start taking more risk to win back that which was lost, just as Admati and Hellwig argue.

However, once you have achieved a position that is unquestionably strong, holding more common equity does not necessarily enhance risk management discipline. My experience in banking is that it may in fact be more likely to breed an undesirable sense of complacency or even to create pressure to improve returns. I know that the later is not a a winning strategy in the long run but in the short run the market frequently does not care.

What is the minimum return an equity investor requires?

One of the problems I find with a simplistic application of Modigliani & Miller’s (M&M) capital irrelevancy argument is that it does not seem to consider if there is a minimum threshold return for an equity investment below which the investment is no longer sufficiently attractive to investors who are being asked to take first loss positions in a company; i.e. where is the line between debt and equity where a return is simply not high enough to be attractive to equity investors?

Reframing the question in this way suggests that the debate between the authors and the bankers may be more about whether risk based capital adequacy models (including stress testing) can be trusted than it is about the limitations of M&M in the real world.

Summary

The author’s solution to prudential supervision of banks is a shock and awe approach to capital that seeks to make the risk of insolvency de minimus for good banks and bad. I have done my best to be open to their arguments and indeed do agree with a number of them. My primary concern with the path they advocate is that I do not believe the extra “skin in the game” generates the risk management benefits they claim.

I see more potential in pursuing a capital structure based on

  • a level of common equity that is robustly calibrated to the needs of a well managed (and well supervised) bank
  • incorporating a well designed counter cyclical capital buffer,
  • supplemented with another robust layer of bail-in capital that imposes real costs (and accountability) on the shareholders and management of banks for whom this level of common equity proves insufficent.

The authors argue that the authorities would never use these bail-in powers for fear of further destabilising funding markets. This is a valid area of debate but I believe they conflate the risks of imposing losses on bank depositors with the kinds of risks that professional bond investors have traditionally absorbed over many centuries of banking. The golden era in which the TBTF factor shielded bank bondholders from this risk is coming to the end but this broader investment class of bond holders has dealt with defaults by all kinds of borrowers. I am not sure why banks would be special in this regard if countries can default. The key issue is that the investors enter into the contract with the knowledge that they are at risk and are being paid a risk premium commensurate with the downside (which may not be that large if investors judge the banks to be well managed).

This is a complex topic so please let me know if I have missed something fundamental or have otherwise mis-represented Admati and Hellwig’s thesis. In the interim, I remain mostly unconvinced …

Tony

  1. It is worth noting that NZ has adopted a different path with respect to deposit protection, rejecting both deposit preference and deposit insurance. They also have a unique policy tool (Open Bank Resolution) that allows the RBNZ to impose losses on deposits as part of the resolution process. They are reviewing the case for deposit insurance and I believe should also reconsider deposit preference.

Why banks are different

A previous post explored the question of whether banks are just like other companies or somehow unique. The post listed three distinctive features I believe 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.

This post will focus on the first two features which I think are related. As a rule, I am a fan of the principle of “strong views, lightly held”. I feel pretty strongly that my arguments for why banks are different are robust but acknowledge that there are contrary views on the question. My earlier post used a paper by Anat Admati and Martin Hellwig (frequently cited as authorities on the issues of bank capital discussed in this post) “The Parade of the Bankers’ New Clothes Continues: 31 Flawed Claims Debunked” as an example of the alternative perspective.

It is up to the reader to determine the validity of my rebuttal of Admati and Hellwig’s arguments but I recently read an interesting paper by Joseph Sommer that I think supports the position I was making for why banks are different. Sommer wrote the paper, titled “ Why Bail-In? And How!”, while working as an assistant vice president and counsel at the Federal Reserve Bank of New York. Central to his analysis is the concept of “financial liabilities”

Financial Liabilities

Sommer argues that one of the features that distinguishes a bank is that they create a special type of liability which he labels “financial liabilities”. He defines a financial liability as one whose value is impaired by the insolvency process. That may sound like a statement of the obvious. Insolvency naturally threatens the value of liabilities via shortfalls in the liquidation value of assets but Sommer is making a different point. He is talking about something more than credit risk impairing the value of these liabilities.

The reason is that “financial liabilities” are also distinguished by the extent to which the function of the financial instrument is to provide liquidity or shift risk; i.e. by the extent to which the liability is a “product” not just a form of finance. Bankruptcy disrupts the ability of these financial liabilities to perform these economic functions.

The customers who own these financial liabilities have a creditor relationship with the bank, just like other liability holders do. However, they do not buy these instruments as “investments”, they are customers buying a product.

“The creditor in such contracts is not primarily an investor: paying money now to get more later. Instead, it wants liquidity, or insurance, or other kind of risk shifting”

Insolvency destroys the value of financial liabilities

“The central policy implication of this article is that Financial liabilities deserve priority treatment in insolvency law but the standard bankruptcy process cannot do this.”

The bankruptcy process seeks to protect the value of the business by protecting the value of business assets. To protect the value of business assets, the process will typically seek to temporarily suspend the rights of liability holders to be repaid.

For non-financial companies, the value of business liabilities in the bankruptcy process is defined by their contractual claim (e.g. the promised payment of principal and interest) and their priority in the loss hierarchy. In theory, that value is not impacted beyond any shortfall in assets versus the priority of the claim the liability has, and the time value of delayed payment.

However, the value of a bank is also embedded in its financial liabilities not just its assets. Consequently, suspending the rights of these financial liabilities impairs the value of the liability in ways that harm the business.

“This notion of a financial liability as a product has implications for insolvency law, apart from priorities. Insolvency law assumes that firms often need a breathing spell from their creditors, so that they can pick themselves up, continue operating, and start reorganizing. It therefore places all claims in a collective procedure and places a moratorium on efforts to collect assets. However, financial products are operations of the financial firm. Freezing performance on a financial product, whether by automatic stay or treatment as a claim, is akin to prohibiting a carmaker in Chapter 11 from making and selling cars, or an airline from selling tickets, buying jet fuel, and flying planes”

Adapting to the challenges of the bank balance sheet

Ideally, insolvency law would preserve the liquidity or risk shifting functions of financial liabilities but the standard bankruptcy process is not designed to deal with this feature of the bank balance sheet. Sommer favours bail-in as a way to overcome the problems of applying the traditional insolvency process to a bank balance sheet. An alternative is to simply require banks to be capitalised with a much higher level of common equity.

Higher common equity is the solution advocated by Admati and Hellwig and most recently by the RBNZ.  I side with Sommer on this question, favouring a combination of:

  • common equity calibrated to make a sound, well managed, well supervised bank Unquestionably Strong,
  • supplemented with sufficient additional loss absorbing “capital” calibrated to what would be required if the bank were high risk, poorly managed and possibly poorly supervised

The distinction I am drawing between the capital requirements of “good” and “bad” banks might be dismissed as splitting hairs but it strikes me as a frequent source of confusion in the debate about how much capital and what type. Good banks don’t actually seem to need much capital whereas bad banks need a lot. Obviously, we don’t know ex ante which banks are good and which are bad. We do know that common equity is the foundation of any capital structure and we could just capitalise all banks with common equity on the basis that they might be bad banks. While not expressed so bluntly, this I think is effectively the solution recently proposed by the RBNZ.

Which solution is better lies outside the scope of this post. I have touched on this question previously in a few posts (see here, here, here, and here) but am yet to bring my thoughts together in one place. The main purpose in this post was simply to introduce readers to an interesting paper that I think adds some useful insights to the question of what makes banks different from non-financial companies.

Conclusion

There are various ways to make the argument that banks are different to non-financial firms. My earlier post highlighted 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). This in turn helps explain why bank supervisors are reluctant to allow large banks to fail in the conventional way that other companies and even countries can (and frequently do).

The argument I developed in the earlier post is a subset of a broader theme in Sommer’s paper. I focussed on the need to protect the value of deposits if they are to function as money. Deposits in Sommer’s argument are part of a broader class of what he labels “financial liabilities”. The conclusion however is the same, bankruptcy can protect the value of non-financial firms but it almost certainly destroys value in banks by impairing the value of financial liabilities. It is not the optimal solution for dealing with a failing bank.

It is also worth reading a paper by Gary Gorton and George Pannacchi titled “Financial Intermediaries and Liquidity Creation” which offers another angle on these issues. They note that credit intermediation between savers and borrowers has traditionally been identified as the key economic role of banks. Banks clearly do intermediation, but they argue that the really critical function of banks is to provide a liquid asset in the form of bank deposits that serve as a form of money (arguably the primary form of money).

The problem is that the capacity of a bank deposit to function as money depends on the ability of uninformed agents to use it without fear of loss; i.e. the extent to which the value of the instrument is insulated from any adverse information about the counterparty (aka bank). There are a variety of ways to make bank deposits liquid in the sense that Gorton/Pennacchi define it (i.e. insensitive to adverse information about the bank) but they argue for solutions where depositors have a sufficiently deep and senior claim on the banks assets that any volatility in their value is of no concern to them. This earlier post offers more detail on Gorton and Pennacchi’s paper.

I intend to try and consolidate these thoughts in a future post that will set out my take on the case for bail-in. In the interim, I can recommend the two papers referenced in this post to anyone seeking to understand bank balance sheets.

Tony

What should count as bank capital?

My last post looked at a RBNZ consultation paper which addressed the question “How much capital is enough?”. The overall quantum of capital the RBNZ arrived at (16% of RWA plus) seemed reasonable but it was less obvious that relying almost entirely on CET1 was the right solution. That prompted me to revisit an earlier consultation paper in which the RBNZ set out its case for why it did not want contingent capital instruments to play a significant role in the capital structure of the banks it supervises. This post explores the arguments the RBNZ marshals to support its position as part of a broader exploration of the debate over what counts as capital.

The traditional approach to this question assumes that common equity is unquestionably the best form of capital from the perspective of loss absorption. Consequently, the extent to which alternative forms of funding count as capital is judged by common equity benchmarks; e.g. the extent to which the funding is a permanent commitment (i.e. no maturity date) and the returns paid to investors depend on the profitability or capacity of the company to pay (failure to pay is not an event of default).

There is no dispute that tangible common equity unquestionably absorbs loss and is the foundation of any company’s capital structure but I believe contingent convertible capital instruments do potentially add something useful to the bank capital management toolkit. I will attempt to make the case that a foundation of common equity, supplemented with some debt that converts to common equity if required, is better than a capital structure comprised solely or largely of common equity.

The essence of my argument is that there is a point in the capital structure where adding contingent convertible instruments enhances market discipline relative to just adding more common equity. The RBNZ discusses the potential value of these structures in their consultation paper:

“49. The theoretical literature on contingent debt explores how these instruments might reduce risk (i.e. lower the probability of insolvency) for an individual bank.  

50. Two effects have been identified. Firstly, adding contingent debt to a bank’s balance sheet directly increases the loss absorbing potential of the bank, relative to issuing pure debt (but not relative to acquiring more common equity). This follows directly from the fact that removing the debt is an essential part of every contingent debt instrument. Secondly, depending on the terms, contingent capital may cause bank management to target a lower level of risk (incentive effects). In other words, in theory, a contingent debt instrument both reduces the probability a bank will incur losses and absorbs losses that do eventuate. Because of both these factors, contingent debt is expected, in theory, to reduce the risk of bank failure.  

51. Focusing on the second of these effects, management incentives, it matters whether, when the debt is written off, holders are compensated in the form of newly issued shares (“conversion”). If conversion is on such a scale as to threaten existing shareholders with a loss of control of the bank, it will be optimal for bank management to target a lower level of risk exposure for a given set of circumstances than would have been the case otherwise. For example, bank management may be less tolerant of asset volatility, and more likely to issue new equity to existing shareholders, when capital is low rather than risk triggering conversion.”

RBNZ Capital Review Paper 2: What should qualify as bank capital? Issues and Options (para 49 – 51) – Emphasis added

So the RBNZ does recognise the potential value of contingent debt instruments which convert into common equity but chose to downplay the benefits while placing much greater weight on a series of concerns it identified.

What’s in a name – The RBNZ Taxonomy of Capital

Before digging into the detail of the RBNZ concerns, it will be helpful to first clarify terminology. I am using the term Contingent Convertible Instruments for my preferred form of supplementary capital whereas much of the RBNZ paper focuses on what it refers to as “Contingent debt instruments“, which it defines in part as “debt that absorbs loss via write-off, which may or may not be followed by conversion”.

I had not picked this up on my first read of the RBNZ paper but came to realise we are talking slightly at cross purposes. The key words to note are “contingent” and “convertible”.

  • The “contingent” part of these instruments is non-negotiable if they are to be accepted as bank regulatory capital. The contingency is either a “non-viability event” (e.g. the supervisor determines that the bank must increase common equity to remain viable) or a CET1 ratio of 5.125% or less (what APRA terms a “loss absorption trigger” and the RBNZ refers to as a “going-concern trigger”)
  • “Conversion” however is optional. Loss absorption is non-negotiable for bank regulatory capital but it can be achieved in two ways. I have argued that loss absorption is best achieved by converting these capital instruments into common equity but prudential regulation is satisfied so long as the instruments are written-off.

I had taken it as given that these instruments would be convertible but the RBNZ places more emphasis on the possibility that conversion “may or may not” follow write-off. Small point but worth noting when evaluating the arguments.

Why does conversion matter?

The RBNZ understandably focuses on the write-off part of the loss absorption process whereas I focus on conversion because it is essential to preserving a loss hierarchy that allocates losses to common equity in the first instance. If we ignore for a moment the impact of bail-in (either by conversion or write-off), the order in which losses are applied to the various sources of funding employed by a bank follows this loss hierarchy:

  • Going Concern:
    • Common Equity Tier 1 (CET1)
    • Additional Tier 1 (AT1)
  • Insolvency – Liquidation or restructuring:
    • Tier 2 (T2)
    • Senior unsecured
    • Super senior
      • Covered bonds
      • Deposits
      • Insured deposits

Under bail-in, writing off a contingent capital instrument generates an increase in common equity that accrues to the existing ordinary shareholders thereby negating the traditional loss hierarchy that requires common equity to be exhausted before more senior instruments can be required to absorb loss.

Conversion is a far better way to effect loss absorption because ordinary shareholders still bear the brunt of any loss, albeit indirectly via the dilution of their shareholding (and associated share price losses). In theory, conversion shields the AT1 investors from loss absorption because they receive common equity equivalent in value to the book value of their claim on the issuer. In practice, it is less clear that the AT1 investors will be able to sell the shares received at the conversion price or better but they are still better off than if they had simply seen the value of their investment written-off. If you are interested in digging deeper, this post looks at how loss absorption works under bail-in.

The RBNZ does recognise this dynamic but still chose to reject these advantages so it is time to look at their concerns.

RBNZ concerns with contingent capital

The RBNZ identified six concerns to justify its in principle decision to exclude the use of contingent capital instruments in the NZ capital adequacy framework.

  1. Possible under-estimation of the tax effects of contingent debt
  2. Reliance on parent entities as purchasers of AT1 contingent debt
  3. Not suitable for retail investors
  4. Banks structured as mutual societies cannot offer contingent debt that includes conversion into common equity
  5. Potential for regulatory arbitrage arising from the tension between tax and capital regulation
  6. Difficulties with exercising regulatory oversight of contingent debt

I don’t imagine the RBNZ is much concerned with my opinion but I don’t find the first three concerns to be compelling. I set out my reasons later in the post but will focus for the moment on three issues that I think do bear deeper consideration. You do not necessarily have to agree with the RBNZ assessment, or the weight they assign to them, but I believe these concerns must be addressed if we are to make the case for contingent debt.

Stronger arguments against contingent debt

1) Contingent debt gives the larger, listed banks a competitive advantage over mutual societies that are unable to issue ordinary shares

The RBNZ notes that all New Zealand banks are able to issue a version of contingent debt that qualifies as capital, but that some types of banks may have access to a broader – and cheaper – range of capital opportunities than others. The current definition of capital is thus in part responsible for a somewhat uneven playing field.

The primary concern seems to be banks structured as mutual societies which are unable to issue ordinary shares. They cannot offer contingent debt that includes conversion and must rely on the relatively more expensive option of writing-off of the debt to effect loss absorption.

I think this is a reasonable concern but I also believe there may be ways to deal with it. One option is for these banks to issue Mutual Equity Interests as has been proposed in Australia. Another option (also based on an Australian proposal) is that the increased requirements for loss absorbing capital be confined to the banks which cannot credibly be allowed to fail or be resolved in any other way. I recognise that this option benefits from the existence of deposit insurance which NZ has thus far rejected.

I need to do bit more research on this topic so I plan to revisit the way we deal with small banks, and mutuals in particular, in a future post.

2) Economic welfare losses due to regulatory arbitrage opportunities in the context of contingent debt

The tax treatment of payments to security holders is one of the basic tests for determining if the security is debt or equity but contingent debt instruments don’t fall neatly into either box. The conversion terms tied to PONV triggers make the instruments equity like when the issuer is under financial stress while the contractual nature of the payments to security holders makes them appear more debt like under normal operating conditions.

I can see a valid prudential concern but only to the extent the debt like features the tax authority relied on in making its determination regarding tax-deductibility somehow undermined the ability of the instrument to absorb loss when required.

There have been instances where securities have been mis-sold to unsophisticated investors (the Monte dei Paschi di Sienna example cited by the RBNZ is a case in point) but it is less obvious that retail investment by itself is sufficient cause to rule out this form of capital.

The only real difference I see over conventional forms of debt is the line where their equity like features come into play. Conventional debt is only ever at risk of loss absorption in the event of bankruptcy where its seniority in the loss hierarchy will determine the extent to which the debt is repaid in full. These new forms of bank capital bring forward the point at which a bank balance sheet can be restructured to address the risk that the restructuring undermines confidence in the bank. The economics of the restructuring are analogous so long as losses are allocated by conversion rather than by write-off alone.

3) Difficulties experienced with the regulatory oversight of contingent debt

Possibly their core concern is that overseeing instrument compliance is a complex and resource-intensive process that the RBNZ believes does not fit well with its regulatory model that emphasises self-discipline and market discipline. The RBNZ highlights two concerns in particular.

  • Firstly the RBNZ has chosen to respond to the challenge of vetting these instruments by instituting a “non-objection process” that places the onus on issuers to confirm that their instruments comply with the capital adequacy requirements.
  • Secondly, notwithstanding the non objection process, the added complexity of the instruments relative to common equity, still requires significant call on prudential resources.

This I think, is the strongest objection the RBNZ raises against contingent debt. Contingent debt securities are clearly more complex than common equity so the RBNZ quite reasonably argues that they need to bring something extra to the table to justify the time, effort and risk associated with them. There is virtually no justification for them if they do, as the RBNZ asserts, work against the principles of self and market discipline that underpin its regulatory philosophy.

Three not so compelling reasons for restricting the use of contingent capital instruments (“in my humble opinion’)

1) Possible under-estimation of the tax effects of contingent debt

The first concern relates to the RBNZ requirement that banks must acknowledge any potential tax implications arising from contingent debt and reflect these potential “tax offsets” in the reported value of capital. Banks are required to obtain a binding ruling from the NZ tax authority (or voluntarily take a tax ”haircut”). The RBNZ acknowledges that a binding ruling can provide comfort that tax is fully accounted for under prudential requirements, but quite reasonably argues that this will only be the case if the ruling that is sought is appropriately specified so as to capture all relevant circumstances.

The RBNZ’s specific concern seems to be what happens when no shares are issued in the event of the contingent loss absorption feature being triggered and hence no consideration is paid to investors in exchange for writing off their debt claim. The bank has made a gain that in principle would create a tax lability but it also seems reasonable to assume that the write off could only occur if the bank was incurring material losses. It follows then that the contingent tax liability created by the write off is highly likely to be set off against the tax losses such that there is no tax to pay.

I am not a tax expert so I may well be missing something but I can’t see a practical risk here. Even in the seemingly unlikely event that there is a tax payment, the money represents a windfall gain for the public purse. That said, I recognise that the reader must still accept my argument regarding the value of having the conversion option to consider it worth dealing with the added complexity.

2) A reliance on parent entities as purchasers of AT1 contingent debt

I and the RBNZ both agree that one of the key planks in the case for accepting contingent debt as bank capital is the beneficial impact on bank risk taking generated by the risk of dilution but the RBNZ argues this beneficial impact is less than it could be when the instrument is issued by a NZ subsidiary to its publicly listed parent.

I may be missing something here but the parent is exposed to dilution if the Non-Viability or Going Concern triggers are hit so I can’t see how that reduces the incentive to control risk unless the suggestion is that NZ management will somehow have the freedom to pursue risky business strategies with no input from their ultimate owners.

3) Retail investors have acquired contingent debt

The RBNZ cites some statistical evidence that suggests that, in contrast to the experience overseas, there appears to be limited uptake by wholesale investors of contingent debt issued by the big four banks. This prompts them to question whether the terms being offered on instruments issued outside the parent group are not sufficiently attractive for sophisticated investors. This concern seems to be predicated on the view that retail will always be the least sophisticated investors so banks will seek to take advantage of their relative lack of knowledge.

It is arguably true that retail investors will tend be less sophisticated than wholesale investors but that should not in itself lead to the conclusion that any issue targeted at retail is a cynical attempt at exploitation or that retail might legitimately value something differently to the way other investors do. The extent that the structures issued by the Australian parents have thus far concentrated on retail, for example, might equally be explained by the payment of franking credit that was more highly valued by the retail segment. Offshore institutions might also have been negative on the Australian market therefore pushing Australian banks to focus their efforts in the domestic market.

I retain an open mind on this question and need to dig a bit deeper but I don’t see how the fact that retail investment dominates the demand for these structures at a point in time can be construed to be proof that they are being mis-sold.

The RBNZ’s answer ultimately lies in their regulatory philosophy

The reason that the RBNZ rejects the use of these forms of supplementary capital ultimately appears to lie in its regulatory philosophy which is based on the following principles

  • Self discipline on the part of the financial institutions they supervise
  • Market discipline
  • Deliberately conservative
  • Simplicity

The RBNZ also acknowledges the value of adopting BCBS consistent standards but this is not a guiding principle. It reserves the right to adapt them to local needs and, in particular, to be more conservative. It should also be noted that the RBNZ has quite deliberately rejected adopting deposit insurance on the grounds (as I understand it) that this encourages moral hazard. They take this a step further by foregoing any depositor preference in the loss hierarchy and by a unique policy of Open Bank Resolution (OBR) under which deposits are explicitly included in the liabilities which can be written down in need to assist in the recapitalisation of an insolvent bank.

In theory, the RBNZ might have embraced contingent convertible instruments on the basis of their consistency with the principles of self and market discipline. The threat of dilution via conversion of the instrument into common equity creates powerful incentives not just for management to limit excessive risk taking but also for the investors to exert market discipline where they perceive that management is not exercising self-discipline.

In practice, the RBNZ seems to have discounted this benefit on the grounds that that there is too much risk, either by design or by some operational failure, that these instruments might not convert to common equity. They also seem quite concerned with structures that eschew conversion (i.e. loss absorption effected by write-off alone) but they could have just excluded these instruments rather than a blanket ban. Having largely discounted or disregarded the potential benefit, the principles of deliberate conservatism and simplicity dictate their proposed policy position, common equity rules.

Summing up

This post only scratches the surface of this topic. My key point is that contingent convertible capital instruments potentially add something useful to the bank capital management toolkit compared to relying entirely on common equity. The RBNZ acknowledge the potential upside but ultimately argue that the concerns they identify outweigh the potential benefits. I have reviewed their six concerns in this post but need to do a bit more work to gain comfort that I am not missing something and that my belief in the value of bail-in based capital instruments is justified.

Tony

How much capital is enough? – The NZ perspective

The RBNZ has delivered the 4th instalment in a Capital Review process that was initiated in March 2017 and has a way to run yet. The latest consultation paper addresses the question “How much capital is enough?”.  The banking industry has until 29 March 2019 to respond with their views but the RBNZ proposed answer is:

  • A Tier 1 capital requirement of 16% of RWA for systemically important banks and 15% of RWA for all other banks
  • The Tier 1 minimum requirement to remain unchanged at 6% (with AT1 capital continuing to be eligible to contribute a maximum of 1.5 percentage points)
  • The proposed increased capital requirement to be implemented via an overall prudential capital buffer of 9-10% of RWA comprised entirely of CET1 capital;
    • Capital Conservation Buffer 7.5% (currently 2.5%)
    • D-SIB Buffer 1.0% (no change)
    • Counter-cyclical buffer 1.5% (currently 0%)

The increase in the capital ratio requirement is proposed to be supplemented with a series of initiatives that will increase the RWA of IRB banks:

  • The RBNZ proposes to 1) remove the option to apply IRB RW to sovereign and bank exposures,  2) increase the IRB scalar (from 1.06 to 1.20) and 3) to introduce an output floor set at 85% of the Standardised RWA on an aggregate portfolio basis
  • As at March 2018, RWA’s produced by the IRB approach averaged 76% of the Standardised Approach and the RBNZ estimate that the overall impact will be to increase the aggregate RWA to 90% of the outcome generated by the Standardised approach (i.e. the IRB changes, not the output floor, drive the increase in RWA)
  • Aggregate RWA across the four IRB banks therefore increases by approximately 16%, or $39bn, compared to March 2018 but the exact impact will depend on how IRB banks respond to the higher capital requirements

The RBNZ has also posed the question whether a Tier 2 capital requirement continues to be relevant given the substantial increase in Tier 1 capital.

Some preliminary thoughts …

There is a lot to unpack in this paper so this post will only scratch the surface of the issues it raises …

  • The overall number that the RBNZ proposes (16%) is not surprising.It looks to be at the lower end of what other prudential regulators are proposing in nominal terms
  • But is in the same ball park once you allow for the substantial increase in IRB RWA and the fact that it is pretty much entirely CET1 capital
  • What is really interesting is the fundamentally different approach that the RBNZ has adopted to Tier 2 capital and bail-in versus what APRA (and arguably the rest of the world) has adopted
    • The RBNZ proposal that the increased capital requirement take the form of CET1 capital reflects its belief that “contingent convertible instruments” should be excluded from what counts as capital
    • Exactly why the RBNZ has adopted this position is a complex post in itself (their paper on the topic can be found here) but the short version (as I understand it) is that they think bail-in capital instruments triggered by non-viability are too complex and probably won’t work anyway.
    • Their suggestion that Tier 2 probably does not have a role in the capital structure they have proposed is logical if you accept their premise that Point of Non-Viability (PONV) triggers and bail-in do not work.
  • The RBNZ highlight a significantly enhanced role for prudential capital buffersI am generally in favour of bigger, more dynamic, capital buffers rather than higher fixed minimum requirements and I have argued previously in favour of the base rate for the counter-cyclical being a positive value (the RBNZ propose 1.5%)
    • But the overall size of the total CET1 capital buffer requirement requires some more considered thought about 1) the role of bail-in  structures and PONV triggers in the capital regulation toolkit (as noted above) and 2) whether the impacts of the higher common equity requirement will be as benign as the RBNZ analysis suggests
  • I am also not sure that the indicative capital conservation responses they have outlined (i.e. discretionary distributions limited to 60% of net earnings in the first 250bp of the buffer, falling to 30% in the next 250bp and no distributions thereafter) make sense in practice.
    • This is because I doubt there will be any net earnings to distribute if losses are sufficient to reduce CET1 capital by 250bp so the increasing capital conservation requirement is irrelevant.
  • Last, but possibly most importantly, we need to consider the impact on the Australian parents of the NZ D-SIB banks and how APRA responds. The increase in CET1 capital proposed for the NZ subsidiaries implies that, for any given amount of CET1 capital held by the Level 2 Banking Group, the increased strength of the NZ subsidiaries will be achieved at the expense of the Australian banking entities
    • Note however that the impact of the higher capital requirement in NZ will tend to be masked by the technicalities of how bank capital ratios are calculated.
      • It probably won’t impact the Level 2 capital ratios at all since these are a consolidated view of the combined banking group operations of the Group as a whole
      • The Level 1 capital ratios for the Australian banks also treat investments in bank subsidiaries relatively generously (capital invested in unlisted subsidiaries is treated as a 400% risk weighted asset rather than a capital deduction).

Conclusion

Overall, I believe that the RBNZ is well within its rights to expect the banks it supervises to maintain a total level of loss absorbing capital of 16% or more. The enhanced role for capital buffers is also a welcome move.

The issue is whether relying almost entirely on CET1 capital is the right way to achieve this objective. This is however an issue that has been debated for many decades with no clear resolution. It will take some time to fully unpack the RBNZ argument and figure out how best to articulate why I disagree. In the interim, any feedback on the issues I have outlined above would be most welcome.

Tony

Revisiting the mortgage risk weight fact check

The ACCC’s Final Report on its “Residential Mortgage Price Inquiry” (Section 4.3) listed four challenges faced by the smaller banks in making decisions about their residential mortgage product offering; specifically 1) APRA’s prudential benchmarks, 2) APRA’s regulatory capital requirements, 3) service levels to brokers and aggregators, and 4) customer loyalty to the big four banks and customer inertia.

The smaller banks undoubtedly face a number of challenges in competing with the bigger banks but I have argued previously that the difference in regulatory capital requirements is overstated.

The ACCC describe the challenge with APRA’s regulatory capital requirements as follows:

For otherwise identical ADIs, the advantage of a 25% average risk weight (APRA’s minimum for IRB banks) compared to the 39% average risk weight of standardised ADIs is a reduction of approximately 0.14 percentage points in the cost of funding the loan portfolio. This difference translates into an annual funding cost advantage of almost $750 on a residential mortgage of $500 000, or about $15 000 over the 30 year life of a residential mortgage (assuming an average interest rate of 7% over that period).

The report does offer some caveats on the size of the difference in risk weights …

This estimate is indicative only. No allowance has been made for the cost to IRB-accredited ADIs of achieving or maintaining their IRB accreditation, or for other differences between IRB and standardised ADIs in funding their residential mortgage portfolios, such as differences in wholesale funding costs and other aspects of APRA’s capital adequacy regime which impose additional capital costs on IRB-accredited banks.

But the commentary I read in the financial press just focussed on the nominal difference in the risk weights (i.e. 25% versus 39%) without any of the qualifications. My early post on this question identified 5 problems with the simplistic comparison cited by the ACCC:

  • Problem 1 – Capital adequacy ratios differ
  • Problem 2 – You have to include capital deductions
  • Problem 3 – The standardised risk weights for residential mortgages seems set to change
  • Problem 4 – The risk of a mortgage depends on the portfolio not the individual loan
  • Problem 5 – You have to include the capital required for Interest Rate Risk in the Banking Book? 

Summing up

My aim in this and the original post was not to defend the big banks but rather to try to contribute some of the knowledge I have acquired working in this area to what I think is an important but misunderstood question. In the interests of full disclosure, I have worked for one of the large Australian banks and may continue to do work for them in the future.

On a pure risk basis, it seems to me that the loan portfolio of a large bank will tend to be more diversified, and hence lower risk, than that of a smaller bank. It is not a “gift” for risk weights to reflect this.

There is a legitimate debate to be had regarding whether small banks should be given (gifted?) an advantage that helps them compete against the big banks. That debate however should start with a proper understanding of the facts about how much advantage the large banks really have and the extent to which their lower risk weights reflect lower risk.

If you disagree tell me what I am missing …