Tag: Bail-Out

Bank capital buffers – room for improvement

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

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

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

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

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

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

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

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

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

4. The entire buffer potentially releasable in a stress.

5. All requirements met with common equity.

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

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

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

No more Additional Tier 1?

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

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

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

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

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

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

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

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

Keep AT1 but make it simpler

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

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

One buffer to rule them all

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

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

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

… seems sound and intuitive to me.

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

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

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

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

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

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

Summing up

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

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

As always let me know what I am missing …

Tony – From the Outside

Australian bank capital adequacy – “a more flexible and resilient capital framework”

This post looks at a Discussion Paper published by APRA in late 2020 titled “A more flexible and resilient capital framework for ADIs” setting out how it proposes to wrap up a number of prior consultations on a variety of aspects of ADI (authorised deposit-taking institution) capital reform in Australia. The next step in the roll out of the revised framework is to conduct a quantitive impact study (QIS) with selected ADIs to ensure that the proposed final standards are appropriately calibrated.

Key elements of the revised framework (effective 1 January 2023) include:
  • More risk-sensitive risk weights (mostly for residential mortgages but also SME lending) that are expected to reduce average risk weights by approximately 10% for Internal Ratings Based (IRB) banks and 7% for banks operating under the Standardised Approach (SA) to capital adequacy,
  • Support for enhanced competition between the big and small ADIs via a series of initiatives intended to limit the differences between the IRB and SA, approaches (though APRA also offers evidence that the existing differences are not as great as some claim),
  • Improved transparency and comparability both with international peer banks and between the big IRB banks and the smaller SA banks
  • Improved flexibility in capital requirements via an increase in the size of regulatory capital buffers.
Improved risk sensitivity (lower risk weights)

Improved risk sensitivity is obviously a two edged sword (capital requirements could increase) but APRA estimates that the overall impact of the proposed revisions will be to reduce average risk weights for IRB ADIs by 10% and by 7% for Standardised ADIs. I have published a couple of posts already on the proposed changes to residential mortgage risk weights (see here and here) so I don’t intend to cover that in any detail in this post.

The main points to note regarding residential mortgages are:

  • Standardised ADIs get
  • IRB ADIs see
    • the higher than Basel “correlation adjustment” currently used to narrow the difference between IRB and SA risk weights replaced by a simple “scalar” adjustment,
    • the existing 20% LGD floor reduced to 10% for approved LGD models and
    • recognition of the risk reduction value of Lenders’ Mortgage Insurance (LMI) in line with the SA.

I have not looked closely at the changes impacting the other RWA exposures but list them here for completeness:

  • SME lending
    • Standardised ADIs – RW applied under the SA will recognise the value of commercial property security while RW for loans not secured by property will be reduced from 100% to 75% for loans less than $1.5m and 85% otherwise
    • IRB ADIs – the thresholds for applying the Retail SME approach and the Corporate SME approach will be increased
  • Other credit portfolios
    • Standardised ADIs see no real change (existing RW are already largely aligned with the Basel framework)
    • IRB ADIs will see the overall credit scalar in the IRB RW formula increased from 1.06x to 1.1x, risk estimates will be more closely aligned to those of overseas peers (but still higher than those peers) and models will be permitted for the calculation of capital requirements for commercial property exposures
  • New Zealand based exposures
    • RWA determined under RBNZ requirements will be used for group capital requirements
Enhanced competition, increased transparency and comparability

The main points to note here are:

  • The risk weight initiatives listed above should address a long standing complaint from the Standardised ADIs that the higher risk weights they are subject to place them at a competitive disadvantage relative to IRB ADIs
  • Note however that APRA has also provided evidence that the difference in capital requirements is not as large as is often claimed and can be justified by differences in the risk of the loan portfolios that different types of ADIs typically hold
  • The extent of any competitive disadvantage due to capital requirements will be further clarified by the requirement that IRB ADIs also publish capital ratios under the Standardised Approach
  • The extent of the differences between the capital requirements applied by APRA and those used to calculate the ratios reported by international peer banks will also be reduced thereby enhancing the transparency of the Australian ADI capital strength versus the international peer groups. This will make the “top quartile” test employed to determine the “unquestionably strong” benchmark simpler and more transparent.
Increased resilience via larger more flexible capital buffers

We noted above that RWA are expected to reduce by around 10 per cent on average for IRB banks and 7 per cent on average for standardised banks. All other things being equal this will translate into a very visible increase in reported capital ratios which requires a recalibration of the balance between minimum requirements and capital buffers:

  • The minimum Prudential Capital Requirement (PCR) remains unchanged in percentage terms (4.5%), as does the minimum threshold for Point of Non-Viability (PONV) conversion (5.125%), but these requirements fall in dollar terms due to the decline in average RWA
  • The Capital Conservation Buffer (CCB) – will be increased by 150 basis points (but only for IRB ADIs)
  • The default Countercyclical Capital Buffer (CCyB) – will be set at 100 basis points (versus zero under the current approach)

Minimum capital requirements

At face value, a reduction in minimum capital requirements sounds like a cause for concern. In theory you can argue that there is a slightly lower amount of CET1 capital available in a scenario in which a bank has breached the PONV threshold that triggers the conversion of Additional Tier 1 and any other layers of loss absorbing capital. In practice, however, this theoretical risk is more than offset by the increase in the CCB and the CCyB. APRA is at pains to emphasise that, all other things being equal, the dollar value of capital that ADI’s currently hold consistent with the Unquestionably Strong benchmarks introduced in 2017 does not change under the revised framework.

With amendments across a number of dimensions, reported capital ratios will inevitably change … However, APRA remains committed to its previous position that an ADI that currently meets the ‘unquestionably strong’ benchmarks under the current framework should have sufficient capital to meet any new requirements. Changing the presentation of capital ratios will not impact overall capital strength or the quantum of capital required to be considered ‘unquestionably strong’; but instead improves comparability, supervisory flexibility and international alignment.

“A more flexible and resilient capital framework for ADIs, APRA Discussion Paper, 8 December 2020 (page 5)

In addition to the increased base levels of CET1, the systemically important ADI are holding increasing amounts of “Additional Loss Absorbing Capital” that can be bailed-in to create CET1 capital in the event that a bank is at risk of breaching the PONV threshold. There are differences of opinion on whether APRA would be willing to pull the trigger to convert these instruments. We won’t know for sure until the time comes, but my colours are nailed to the assumption that APRA will much prefer to see shareholders get diluted rather than having to use government funds to bail-out a bank.

Capital Conservation Buffer

The 150bp expansion in the CCB only applies to IRB ADIs. APRA attributes this to the need to respond to “the greater level of risk sensitivity inherent in the IRB approach” (page 16 of the Discussion Paper). They don’t actually use the term but I think of this as a means of absorbing some of the pro-cyclicality that is inherent in any risk sensitive capital adequacy measure.

A simple way to think about this change is to link the 150bp increase to the roughly equivalent benefit of the 10% decline in RWA expected to flow from RWA changes set out in the paper. We note however that SA gets 7% decline due to improved risk sensitivity but no equivalent increase in CCB. So we get enhanced risk sensitivity in the IRB approach via the revised risk weights without exacerbating the concern about the difference in capital requirements.

However the increased risk sensitivity of the IRB approach also manifests in heightened sensitivity to an economic downturn. All other things being equal both Standardised and IRB ADIs should face similar increases in loan loss charges. The impact on IRB ADI capital ratios is however amplified by the increase in average RWs under stress. I don’t have any hard data to refer to but would not be surprised if the RWA inflation effect contributed another 150bp to the decline in capital ratios we see quoted in stress testing results under this new framework.

Viewed from this perspective the expanded CCB not only neutralises the benefit of lower IRB risk weights, it also helps absorb the increased sensitivity to declines in capital ratios that IRB ADIs can be expected to experience under a stress scenario.

Counter-cyclical Capital Buffer

The CCyB has, for me at least, always been a sound idea badly executed. It became part of the international macro prudential toolkit in 2016 and is intended to ensure that, under adverse conditions, the banking sector in aggregate has sufficient surplus capital on hand required to maintain the flow of credit in the economy without compromising its compliance with prudential requirements.

A key feature in the original Basel Committee design specification is that the buffer is intended to be deployed in response to high levels of aggregate credit growth (i.e high relative to the sustainable long term trend rates whatever that might be) which their research has identified as an indicator of heightened systemic risk. That does not preclude bank supervisors from deploying the buffer at other times as they see fit, but pro-actively responding to excess credit growth has been a core part of the rationale underpinning its development.

The idea of having a buffer that can be released in response to a downturn makes perfect sense but the analytical structure the Basel Committee developed to guide its deployment seems unnecessarily complex. The simple non-zero default level that APRA proposes to adopt is arguably a better (if not the best) approach and one that other countries are already pursuing (see here, here and here).

None of this pro-cyclicality benefit is spelled out in the material APRA released so I may be reading too much into the material. If I am analysing it correctly if is a subtle but still useful benefit of the package of changes that APRA is pursuing.

Conclusion

Broadly speaking, I think there is a lot to like in the revised framework that APRA is pursuing

  • Risk weights that are both more risk sensitive but also more closely aligned under the two approaches to capital adequacy measurement (IRB and Standardised)
  • An increased share of the capital requirement allocated to buffers that can be used rather than minimum requirements that can’t
  • A better approach to setting the CCyB

My primary concern is that the amplified pro-cyclicality in capital ratios that is seemingly inherent in any risk sensitive capital framework seems likely to increase but there is very little discussion of this factor . There are tools to manage the impact but one of the key lessons I have taken away from four decades in this game is that the markets hate surprises. Far better to quantify the extent of any amplified pro-cyclicality in capital ratios prior to the next crisis than to try to explain the impacts when capital ratios start to decline more quickly than expected during the next downturn/crisis.

Let me know what I am missing …

Tony – From the Outside

Some of the backstory

The idea that Australian banks needed to be “Unquestionably Strong” has dominated the local capital adequacy discussion for the past few years. The idea originated in a recommendation of the Australian Financial System Inquiry (2014) based on the rationale that Australian banks should both be and, equally importantly, be perceived to be more resilient than the international peers with which they compete for funding in the international capital markets.In July 2017, APRA translated the FSI recommendation into practical guidance in an announcement supported by a longer information paper.

For most people, this all condensed into a very simple message, the systemically important Australian banks needed to maintain a Common Equity Tier 1 ratio of at least 10.5%. The smaller banks have their own Unquestionably Strong benchmark but most of the public scrutiny seems to have focussed on the larger banks.

In the background, an equally important discussion has been playing out regarding the extent to which the Unquestionably Strong framework should take account of the “comparability” and “transparency” of that measure of strength and the ways in which “flexibility” and “resilience” could be added to the mix. This discussion kicked off in earnest with a March 2018 discussion paper (covered in more detail here) and has come to a conclusion with the December 2020 release of the APRA Discussion Paper explored in the post above.

Allowing companies to fail

I suspect (but can’t prove) that creative destruction is one of the under appreciated factors that underpin the health of the economy. There is quite a lot of evidence however that creative destruction has been suppressed since the 2008 Global Financial Crisis. The rights and wrongs of the extent to which bail-outs were and continue to be necessary is too big a topic to cover in this post.

For the record, I do believe that the bail-outs of the banks were necessary at the time but that “bail-in” gives bank supervisors a very real option to avoid having to do this in the future. The increase in capital requirements are also likely to reduce the risk of a bail-in being required. Others may disagree and my views chiefly relate to the Australian banking system which is where my professional expertise is based. The issues associated with COVID-19 raise a whole lot of related but, in many ways, different issues. At the risk of stating the obvious, it’s complicated.

Against that background, I found this short article published on the VoxEU website worth reading as another reminder of the value of allowing companies to fail and/or be restructured. The conclusion of the article (copied below) gives you the key points the authors derive from their research

We investigate a large number of stakeholders that could be negatively affected by a fire sale but find little evidence for negative externalities. The main effect of fire sales is a wealth transfer from the seller to the buyer. Thus, from a welfare perspective, the costs associated with fire sales of corporate assets are much lower than previously thought based on an analysis of seller costs only. From a policy perspective, these findings indicate that the merits of bailouts as a response to the potential losses associated with fire sales are limited, especially given the moral hazard and the other distortions caused by these bailouts. 

We recognise that the economic shock caused by the COVID-19 pandemic is unparalleled since the WWII and the Great Depression, and hence, some emergency measures and bailouts were likely necessary to prevent a meltdown of economic activity. However, one difference between the current crisis and the Global Crisis is the apparent lack of fire sales of struggling companies or investments into such companies at fire-sale prices. Warren Buffett’s Berkshire Hathaway, for instance, invested $5 billion in Goldman Sachs in September 2008 and $3 billion in General Electric in October 2008, while Warren Buffett’s firm has not undertaken any major investments during the COVID-19 crisis (Financial Times 2020). Our results therefore suggest that, at least at the margin, fire sales would have been an effective alternative to bailouts, especially for large bailouts such as for the airlines in the US.

“The merits of fire sales and bailouts in light of the COVID-19 pandemic”, Jean-Marie Meier and Henri Servaes, 18 January 2021.

Bank deposits – turning unsecured loans to highly leveraged companies into (mostly) risk free assets – an Australian perspective

The ability to raise funding via “deposits” is one of the things that makes banks different from other types of companies. As a rule bank deposits benefit from a variety of protections that transform what is effectively an unsecured loan to a highly leveraged company into an (arguably) risk free asset.

This rule is not universal however. The NZ banking system, for example, had (at the time this post was written) a distinctly different approach to bank deposits that not only eschews the protections Australian depositors take for granted but also has the power, via its Open Banking Resolution regime, to write down the value of bank deposits if required to ensure the solvency and viability of a bank. But some form of protection is common.

I previously had a go at the question of “why” bank deposits should be protected here.

This post focuses on the mechanics of “how” AUD denominated deposits held with APRA authorised deposit-taking institutions incorporated in Australia (“Australian ADIs” or “Australian banks”) are protected. In particular, I attempt to rank the relative importance of the various protections built into the Australian system. You may not necessarily agree with my ranking and that is OK – I would welcome feedback on what I may be missing.

Multiple layers of protection

Australian bank deposits benefit from multiple layers of protection:

  1. The risk taking activities of the banks are subject to a high level of supervision and regulation (that is true to varying degrees for most banking systems but Australian standards do seem to be at the more conservative end of the spectrum where Basel Committee standards offer a choice),
  2. The target level of Common Equity Tier 1 (CET1) capital required to support that risk must meet the standard of being “Unquestionably Strong”,
  3. This core capital requirement is supported by a series of supplementary layers of loss absorbing capital that can be converted into equity if the viability of the bank as a going concern comes into doubt,
  4. The deposits themselves have a priority super senior claim on the Australian assets of the bank should it fail, and
  5. The timely repayments of AUD deposits up to $250,000 per person per bank is guaranteed by the Australian Government.

Deposit preference rules …

The government guarantee might seem like the obvious candidate for the layer of protection that counts for the most, but I am not so sure. All the layers of protection obviously contribute but my vote goes to deposit preference. The capacity to bail-in the supplementary capital gets an honourable mention. These seem to me to be the two elements that ultimately underwrite the safety of the majority of bank deposits (by value) in Australia.

The other elements are also important but …

Intensive supervision clearly helps ensure that banks are well managed and not taking excessive risks but experience demonstrates that it does not guarantee that banks will not make mistakes. The Unquestionably Strong benchmark for CET1 capital developed in response to one of the recommendations of the 2014 Financial System Inquiry also helps but again does not guarantee that banks will not find some new (or not so new) way to blow themselves up.

At face value, the government guarantee seems like it would be all you need to know about the safety of bank deposits (provided you are not dealing with the high quality problem of having more than AUD250,000 in your bank account). When you look at the detail though, the role the government guarantee plays in underwriting the safety of bank deposits seems pretty limited, especially if you hold you deposit account with one of the larger ADIs. The first point to note is that the guarantee will only come into play if a series of conditions are met including that APRA consider that the ADI is insolvent and that the Treasurer determines that it is necessary.

In practice, recourse to the guarantee might be required for a small ADI heavily reliant on deposit funding but I suspect that this chain of events is extremely unlikely to play out for one of the bigger banks. That is partly because the risk of insolvency has been substantially reduced by higher CET1 requirements (for the larger ADI in particular) but also because the government now has a range of tools that allow it to bail-in rather than bail-out certain bank creditors that rank below depositors in the loss hierarchy. There are no great choices when dealing with troubled banks but my guess is that the authorities will choose bail-in over liquidation any time they are dealing with one of the larger ADIs.

If deposit preference rules, why doesn’t everyone do it?

Banking systems often seem to evolve in response to specific issues of the day rather than being the result of some grand design. So far as I can tell, it seems that the countries that have chosen not to pursue deposit preference have done so on the grounds that making deposits too safe dilutes market discipline and in the worst case invites moral hazard. That is very clearly the case in the choices that New Zealand has made (see above) and the resources they devote to the disclosure of information regarding the relative risk and strength of their banks.

I understand the theory being applied here and completely agree that market discipline should be encouraged while moral hazard is something to be avoided at all costs. That said, it does not seem reasonable to me to expect that the average bank deposit account holder is capable of making the risk assessments the theory requires, nor the capacity to bear the consequences of getting it wrong.

Bank deposits also function as one of the primary forms of money in most developed economies but need to be insulated from risk if they are to perform this role. Deposit preference not only helps to insulate this component of our money supply from risk, it also tends to transfer the risk to investors (debt and equity) who do have the skills and the capacity to assess and absorb it, thereby encouraging market discipline.

The point I am making here is very similar to the arguments that Grant Turner listed in favour of deposit protection in a paper published in the RBA Bulletin.

There are a number of reasons why authorities may seek to provide greater protection to depositors than to other creditors of banks. First, deposits are a critical part of the financial system because they facilitate economic transactions in a way that wholesale debt does not. Second, they are a primary form of saving for many individuals, losses on which may result in significant adversity for depositors who are unable to protect against this risk. These two characteristics also mean that deposits are typically the main source of funding for banks, especially for smaller institutions with limited access to wholesale funding markets. Third, non-deposit creditors are generally better placed than most depositors to assess and manage risk. Providing equivalent protection arrangements for non-deposit creditors would weaken market discipline and increase moral hazard.

Depositor Protection in Australia, Grant Turner, RBA Bulletin December Quarter 2011 (p45)

For a more technical discussion of these arguments I can recommend a paper by Gary Gorton and George Pennacchi titled “Financial Intermediation and Liquidity Creation” that I wrote about in this post.

Deposit preference potentially strengthens market discipline

I argued above that deposit preference potentially strengthens market discipline by transferring risk to debt and equity investors who have the skills to assess the risk, are paid a risk premium for doing so and, equally as importantly, the capacity to absorb the downside should a bank get into trouble. I recognise of course that this argument is strongest for the larger ADIs which have substantial layers of senior and subordinated debt that help ensure that deposits are materially insulated from bank risk. The capacity to bail-in a layer of this funding, independent of the conventional liquidation process, further adds to the protection of depositors while concentrating the role of market discipline where it belongs.

This market discipline role is one of the chief reasons I think “bail-in” adds to the resilience of the system in ways that higher equity requirements do not. The “skin in the game” these investors have is every bit as real as that the equity investors do, but they have less incentive to tolerate excessive or undisciplined risk taking.

The market discipline argument is less strong for the smaller ADIs which rely on deposits for a greater share of their funding but these entities account for a smaller share of bank deposits and can be liquidated if required with less disruption with the assistance of the government guarantee. The government guarantee seems to be more valuable for these ADIs than it is for the larger ADIs which are subject to a greater level of self-insurance.

Deposit preference plus ex ante funding of the deposit guarantee favours the smaller ADI

Interestingly, the ex ante nature of the funding of the government guarantee means that the ADIs for which it is least valuable (the survivors in general and the larger ADI’s in particular) are also the ones that will be called upon to pay the levy to make good any shortfalls not covered by deposit preference. That is at odds with the principle of risk based pricing that features in the literature about deposit guarantees but arguably a reasonable subsidy that assists the smaller ADIs to compete with larger ADI that have the benefit of risk diversification and economies of scale.

Summing up

If you want to dig deeper into this question, I have summarised the technical detail of the Australian deposit protection arrangements here. It is a little dated now but I can also recommend the article by Grant Turner published in the RBA Bulletin (December 2011) titled “Depositor Protection in Australia” which I quoted from above.

As always, it is entirely possible that I am missing something – if so let me know.

Tony – From The Outside

When safety proves dangerous …

… is the title of a post on the Farnham Street blog that provides a useful reminder of the problem of “risk compensation”; i.e. the way in which measures designed to make us safer can be a perverse prompt for us to take more risk because we feel safer. I want to explore how these ideas apply to bank capital requirements but will first outline the basic ideas covered by Farnham Street.

we all internally have a desired level of risk that varies depending on who we are and the context we are in. Our risk tolerance is like a thermostat—we take more risks if we feel too safe, and vice versa, in order to remain at our desired “temperature.” It all comes down to the costs and benefits we expect from taking on more or less risk.

The notion of risk homeostasis, although controversial, can help explain risk compensation.

The classic example is car safety measures such as improved tyres, ABS braking systems, seat belts and crumple zones designed to protect the driver and passengers. These have helped reduce car fatality rates for the people inside the car but not necessarily reduced accident rates given that drivers tend to drive faster and more aggressively because they can. Pedestrians are also at greater risk.

Farnham Street suggests the following lessons for dealing with the problem risk compensation:

  1. Safety measures are likely to be more effective is they are less visible
  2. Measures designed to promote prudent behaviour are likely to be more effective than measures which make risky behaviour safer
  3. Recognise that sometimes it is better to do nothing if the actions we take just leads to an offset in risk behaviour somewhere else
  4. If we do make changes then recognise that we may have to put in place other rules to ensure the offsetting risk compensating behaviour is controlled
  5. Finally (and a variation on #3), recognise that making people feel less safe can actually lead to safer behaviour.

If you are interested in this topic then I can also recommend Greg Ip’s book “Foolproof” which offers a good overview of the problem of risk compensation.

Applying these principles to bank capital requirements

The one area where I would take issue with the Farnham Street post is where it argues that bailouts and other protective mechanisms contributed to scale of the 2008 financial crisis because they led banks to take greater risks. There is no question that the scale of the crisis was amplified by the risks that banks took but it is less obvious to me that the bailouts created this problem.

The bailouts were a response to the problem that banks were too big to fail but I can’t see how they created this problem; especially given that the build up of risk preceded the bailouts. Bailouts were a response to the fact that the conventional bankruptcy and restructure process employed to deal with the failure of non-financial firms simply did not work for financial firms.

It is often asserted that bankers took risks because they expected that they would be bailed out; i.e/ that banks deliberately and consciously took risk on the basis that they would be bailed out. I can’t speak for banks as a whole but I have never witnessed that belief in the four decades that I worked in the Australian banking system. Never attribute to malice what can be equally explained by mistaken beliefs. I did see bankers placing excessive faith in the economic capital models that told them they could safely operate with reduced levels of capital. That illusion of knowledge and control is however a different problem altogether, largely to do with not properly understanding the distinction between risk and uncertainty (see here and here).

If I am right, that would suggest that making banks hold more capital might initially make them safer but might also lead to banks looking for ways to take more risk. This is a key reason why I think the answer to safer banks is not just making them hold higher and higher levels of common equity. More common equity is definitely a big part of the answer but one of the real innovations of Basel 3 was the development of new forms of loss absorbing capital that allow banks to be recapitalised by bail-in rather than bail-out.

If you want to go down the common equity is the only solution path then it will be important to ensure that Farnham Street Rule #4 above is respected; i.e. bank supervisors will need to ensure that banks do not simply end up taking risks in places that regulation or supervision does not cover. This is not a set and forget strategy based on the idea that increased “skin in the game” will automatically lead to better risk management.

Based on my experience, the risk of common equity ownership being diluted by the conversion of this “bail-in” capital is a far more effective constraint on risk taking than simply requiring banks to hold very large amounts of common equity. I think the Australian banking system has this balance about right. The Common Equity Tier 1 requirement is calibrated to a level intended to make banks “Unquestionably Strong”. Stress testing suggest that this level of capital is likely to be more than sufficient for well managed banks operating with sensible risk appetites but banks (the larger ones in particular) are also required to maintain a supplementary pool of capital that can be converted to common equity should it be required. The risk that this might be converted into a new pool of dilutive equity is a powerful incentive to not push the boundaries of risk appetite.

Tony – From the Outside

Debt jubilees revisited

I flagged a post by Michael Reddell (Croaking Cassandra) on the (admittedly wonky) topic of debt jubilees. This is not a general interest topic by any means but I am interested in economic history and the role of debt in the economy in particular so this caught my interest.

Michael has returned to the topic here focussing on a book by Michael Hudson titled “… and forgive them their debts: Lending, Foreclosure and Redemption from the Bronze Age Finance to the Jubilee Year” and a call by Steve Keen calling for widespread government funded debt forgiveness as part of the response to the COVID 19 recession. Michael is not a fan of the idea and I think sets out a quite good summary of the case against a modern debt jubilee.

I have copied a short extract from his post here

Keen, for example, emphasises the high level of housing debt in countries like New Zealand and Australia.  But it is mostly a symptom not of hard-hearted banks but of governments (central and local) that keep on rendering urban land artificially scarce, and then –  in effect –  compelling the young to borrow heavily from, in effect, the old to get on the ladder of home ownership.   I count that deeply unconscionable and unjust.  But the primary solution isn’t debt forgiveness –   never clear who is going to pay for this –  but fixing the problem at source, freeing up land use law.  The domestic-oriented elites of our society might not like it –  any more than their peers in ancient Mesopotomia were too keen on the remission –  but that is the source of the problem.  Fix that and then there might be a case for some sort of compensation scheme for those who had got so highly-indebted, but at present –  distorted market and all –  the highly indebted mostly have an asset still worth materially more (a very different situation from a subsistence borrowing in the face of extreme crop failure).

… and you can read the whole post here.

Michael has I think some good points to make regarding the causes of escalating housing debt. One thing he does not cover is the extent to which direct bail outs and extraordinary monetary policy support has contributed to the escalating level of debt. This is a huge topic in itself but I suspect that some of the increasing debt burden can be attributed to the fact that we have chosen not to allow debts to be written down or restructured in previous crises. I think there were legitimate reasons for not imposing losses on bank debt during the GFC but the subsequent development of a “bail-in” capacity should mean that bank supervisors and the government will have a better set of choices in the next banking crisis.

Tony – From The Outside