Digital money – FT Alphaville

FT Alphaville is one of my go to sources for information and insight. The Alphaville post flagged below discusses the discussion paper recently released by the Bank of England on the pros and cons of a Central Bank Digital Currency. It is obviously a technical issue but worth at least scanning if you have any interest in banking and ways in which the concept of “money” may be evolving.

Read on ftalphaville.ft.com/2020/03/12/1584053069000/Digital-stimulus/

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

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

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

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

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

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

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

Tony

Too much information

This post is possibly (ok probably) a bit technical but touches on what I think is an important issue in understanding how the financial system operates. The conventional wisdom as I understand it is that markets thrive on information. I think that is true in some cases but it may not be necessarily true for all markets. If the conventional wisdom is wrong then there are important areas of market and bank regulation that probably need to be reconsidered.

I have written on this topic before in relation to papers by Gary Gorton and Bengt Holmstrom. These papers developed an analytical argument in favour of certain assets (or markets) being “information insensitive”. That argument makes intuitive sense to me and I have used these arguments in a couple of previous posts; one titled “Why banks are different” and another titled “Deposit insurance and moral hazard“.

I hope to eventually do a longer piece where I can bring all these ideas together but the purpose today is simply to flag an interesting post (and associated paper) I came across that offers some empirical evidence in favour of the thesis. The post is titled “(When) Does Transparency Reduce Liquidity” and you can find the paper of the same name here.

This extract from the blog post I think captures the key ideas:

“To sum up, our findings can be grouped under two headings. The first is that more information in financial markets is not always beneficial. It can reduce rather than increase trading and liquidity.

The second is that one size does not fit all in terms of gauging the impact of transparency on liquidity. For the safest of the MBS securities, the impact of transparency is negligible, while for the riskiest, transparency enhances liquidity. It is in the broad middle of the risk spectrum that liquidity is negatively impacted.

Our findings ought to be of interest to regulators on both sides of the Atlantic. In order to promote transparency and to bolster market discipline, supervisors have imposed various loan-level requirements in both Europe and the United States. The assumption seems to be that more transparency is always a good thing.

In such a climate, there has been insufficient investigation or understanding of the effects, including the negative effects, of such requirements on MBS market liquidity. Our work, we believe, begins to put this right.

“(When) Does Transparency Reduce Liquidity?” by professors Karthik Balakrishnan at Rice University, Aytekin Ertan at London Business School, and Yun Lee at Singapore Management University and London Business School. Posted on “The CLS Blue Sky Blog” October 30 2019

Summing up

If this thesis is correct (i.e. that there are certain types of funding that should be “information insensitive” by design and that it is a mistake to apply to money markets the lessons and logic of stock markets) then this has implications for:

  • thinking about the way that bank capital structure should be designed,
  • questions like deposit preference and deposit insurance, and
  • how we reconcile the need to impose market discipline on banks while ensuring that their liquidity is not adversely impacted.

I have not as yet managed to integrate all of these ideas into something worth sharing but the post referenced above and the associated paper are definitely worth reading if you are engaged with the same questions. If you think I am missing something then please let me know.

Tony

The rise of digital money

Given the central role that money plays in our economy, understanding how the rise of digital money will play out is becoming increasingly important. There is a lot being written on this topic but today’s post is simply intended to flag a paper titled “The Rise of Digital Money” that is one of the more useful pieces of analysis that I have come across. The paper is not overly long (20 pages) but the authors (Tobias Adrian and Tommaso Mancini-Griffoli) have also published a short summary of the paper here on the VOX website maintained by the Centre for Economic Policy Research.

Part of the problem with thinking about the rise of digital money is being clear about how to classify the various forms. The authors offer the following framework that they refer to as a Money Tree.

Adrian, T, and T Mancini-Griffoli (2019), “The rise of digital currency”, IMF Fintech Note 19/01.

This taxonomy identifies four key features that distinguish the various types of money (physical and digital):

  1. Type – is it a “claim” or an “object”?
  2. Value – is it the “unit of account” employed in the financial system, a fixed value in that unit of account, or a variable value?
  3. Backstop – if there is a fixed value redemption, is that value “backstopped” by the government or does it rely solely on private mechanisms to support the fixed exchange rate?
  4. Technology – centralised or decentralised?

Using this framework, the authors discuss the rise of stablecoins

“Adoption of new forms of money will depend on their attractiveness as a store of value and means of payment. Cash fares well on the first count, and bank deposits on both. So why hold stablecoins? Why are stablecoins taking off? Why did USD Coin recently launch in 85 countries,1 Facebook invest heavily in Libra, and centralised variants of the stablecoin business model become so widespread? Consider that 90% of Kenyans over the age of 14 use M-Pesa and the value of Alipay and WeChat Pay transactions in China surpasses that of Visa and Mastercard worldwide combined.

The question is all the more intriguing as stablecoins are not an especially stable store of value. As discussed, they are a claim on a private institution whose viability could prevent it from honouring its pledge to redeem coins at face value. Stablecoin providers must generate trust through the prudent and transparent management of safe and liquid assets, as well as sound legal structures. In a way, this class of stablecoins is akin to constant net asset value funds which can break the buck – i.e. pay out less than their face value – as we found out during the global financial crisis. 

However, the strength of stablecoins is their attractiveness as a means of payment. Low costs, global reach, and speed are all huge potential benefits. Also, stablecoins could allow seamless payments of blockchain-based assets and can be embedded into digital applications by an active developer community given their open architecture, as opposed to the proprietary legacy systems of banks. 

And, in many countries, stablecoins may be issued by firms benefitting from greater public trust than banks. Several of these advantages exist even when compared to cutting-edge payment solutions offered by banks called fast-payments.2 

But the real enticement comes from the networks that promise to make transacting as easy as using social media. Economists beware: payments are not the mere act of extinguishing a debt. They are a fundamentally social experience tying people together. Stablecoins are better integrated into our digital lives and designed by firms that live and breathe user-centric design. 

And they may be issued by large technology firms that already benefit from enormous global user bases over which new payment services could spread like wildfire. Network effects – the gains to a new user growing exponentially with the number of users – can be staggering. Take WhatsApp, for instance, which grew to nearly 2 billion users in ten years without any advertisement, based only on word of mouth!”

“The rise of digital currency”, Tobias Adrian, Tommaso Mancini-Griffoli 09 September 2019 – Vox CEPR Policy Portal

The authors then list the risks associated with the rise of stablecoins:

  1. The potential disintermediation of banks
  2. The rise of new monopolies
  3. The threat to weak currencies
  4. The potential to offer new opportunities for money laundering and terrorist financing
  5. Loss of “seignorage” revenue
  6. Consumer protection and financial stability

These risks are not dealt with in much detail. The potential disintermediation of banks gets the most attention (the 20 page paper explores 3 scenarios for how the disintermediation risk might play out).

The authors conclude with a discussion of what role central banks play in the rise of digital currency. They note that many central banks are exploring the desirability of stepping into the game and developing a Central Bank Digital Currency (CBDC) but do not attempt to address the broader question of whether the overall idea of a CBDC is a good one. They do however explore how central banks could work with stablecoin providers to develop a “synthetic” form of central bank digital currency by requiring the “coins” to be backed with central bank reserves.

This is effectively bringing the disrupters into the fold by turning them into a “narrow bank”. Izabella Kaminska (FT Alphaville) has also written an article on the same issue here that is engagingly titled “Why dealing with fintechs is a bit like dealing with pirates”.

The merits of narrow banking lie outside the scope of this post but it a topic with a very rich history (search on the term “Chicago Plan”) and one that has received renewed support in the wake of the GFC. Mervyn King (who headed the Bank of England during the GFC), for example, is one prominent advocate.

Hopefully you found this useful, if not my summary then at least the links to some articles that have helped me think through some of the issues.

Tony

Bank funding costs and capital structure – what I missed

A recent post looked at a Bank of England paper that offered evidence that the cost of higher capital requirements will be mitigated by a reduction in leverage risk which translates into lower borrowing costs and a decline in the required return equity. My post set out some reasons why I struggled with this finding.

My argument was that,

  • in banking systems where the senior debt rating of banks assumed to be Too Big To Fail is supported by an implied assumption of government support (such as Australia),
  • increasing the level of subordinated debt could reduce the value of that implied support,
  • however, senior debt itself does not seem to be any less risky (the senior debt rating does not improve), and
  • the subordinated debt should in theory be more risky if it reduces the value of the assumption of government support.

Fortunately, I also qualified my observations with the caveat that it was possible that I was missing something. Recent issuance of Tier 2 debt by some Australian banks offers some more empirical evidence that does seem to suggest that the cost of senior debt can decline in response to the issuance of more junior securities and that the cost of subordinated debt does not seem to be responding in the way that the theory suggests.

My original argument was I think partly correct. The prospect of the large Australian banks substantially increasing the relative share of Tier 2 debt in their liability structure has not resulted in any improvement in the AA- senior debt rating of the banks subject to this Total Loss Absorbing Capital requirement. So senior debt does not seem to be any less risky.

What I missed was the impact of the supply demand dynamic in a low interest rate environment where safe assets are in very short supply.

The senior debt in my thesis is no less risky but the debt market appears to be factoring in the fact that the pool of AA- senior debt is likely to shrink relative to what was previously expected. Investors who have been struggling for some time to find relatively safe assets with a decent yield weigh up the options. A decent yield on safe assets like they used to get in the old days would obviously be preferable but that is not on offer so they pay up to get a share of what is on offer.

The subordinated debt issued by these banks might be more risky in theory to the extent that bail-in is now more credible but if you do the analysis and conclude that the bank is well managed and low risk then you discount the risk of being bailed-in and take the yield. Again the ultra low yield on very safe assets and the shortage of better options means that you probably bid strongly to get a share of the yield on offer.

Summing up. The impacts on borrowing costs described here may look the same as what would be expected if the Modigliani-Miller effect was in play but the underlying driver appears to be something else.

It remains possible that I am still missing something but hopefully this post moves me a bit closer to a correct understanding of how capital structure impacts bank funding costs …

Tony

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)).”

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.

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

APRA’s proposed revisions to capital requirements for residential mortgages

… there is a lot to like in what APRA have proposed but also some issues that would benefit from further thought

Many readers will be aware that APRA released a Discussion Paper (DP) last week titled “Revisions to the capital framework for authorised deposit-taking institutions”.   The paper sets out APRA’s proposed changes to ADI capital requirements defined by the Internal Ratings Based Approach (IRB) and Standardised Approach to Credit Risk, Interest Rate Risk in the Banking Book (IRRBB) and Operational Risk. The focus of this post will be the proposals impacting credit risk capital requirements for residential mortgage lending. This post presupposes that the reader is familiar with the detail of what APRA has proposed. For those of you who have not yet got around to reading the whole paper I have added a short summary of the proposals below (see “APRA’s proposals – in more detail”).

My gut reaction is that there is a lot to like in what APRA have proposed but there are also issues that deserve further consideration in order to address the risk of unintended consequence and to better deliver on the objectives of consistency, transparency and competitive neutrality.

Proposals which make sense to me:

  • The increased risk sensitivity of the proposed standardised RWs for residential mortgages is, I believe, a material enhancement of the capital adequacy framework
  • There are arguments (and indeed evidence) for why investor property loans can be as low risk as owner occupier loans (most of the  time) but APRA’s desire to address the systemic tail risk of this form of lending is I think an understandable policy objective for a prudential regulator to pursue
  • Continuing to pursue higher IRB RW via changes to the correlation factor also looks to be a better approach than the 20% floor on LGD currently applied and thankfully also up for revision
  • Applying a higher correlation factor to low PD loans also makes intuitive sense, especially if your primary concern is the systemic risk associated with the residential mortgage lending that dominates the balance sheets of your banking system
  • In addition, the potential for the correlation adjustment to reduce the sensitivity of residential mortgage RWA to the economic cycle (and hence reduce the risk of pro-cyclical stress on capital ratios) is particularly welcome though I believe there is much more to do on this general issue
  • The support for Lender’s Mortgage Insurance (LMI) is also welcome

Areas where I believe the proposed revised capital framework could be improved (or at least benefit from some more thought):

  • The discussion of relative standardised and IRB RW does not address the fact IRB banks are required to hold additional capital to cover any shortfall between loan loss provisions and Regulatory Expected Loss (REL)
  • Residential mortgage portfolios subject to the standardised approach should be subject to a minimum average RW in the same way that IRB portfolios are currently constrained by the 25% floor
  • Applying a fixed scalar to Credit RWA can be problematic as the composition of the loan portfolio continues to evolve

The discussion of comparative IRB and Standardised RW you typically encounter seems to assume that the two approaches are identical in every aspect bar the RW but people working at the coal face know that the nominal RW advantage the IRB banks have has been partly offset by a higher exposure measure the RW are applied to. It appears that APRA’s proposed revisions will partly address this inconsistency by requiring banks using the Standardised Approach to apply a 100% Credit Conversion Factor (CCF) to undrawn loan limits.  IRB banks are also required to take a Common Equity Tier 1 deductions for the shortfall between their loan loss provisions and REL. The proposed revisions do nothing to address this area of inconsistency and in fact the Discussion Paper does not even acknowledge the issue.

Residential mortgage portfolios subject to the standardised approach should be subject to a minimum average RW in the same way that IRB portfolios are constrained. The majority of new residential mortgages are originated at relatively high LVR (most at 70% plus and a significant share at 80% plus), but the average LVR will be much lower as principal is repaid (and even more so if you allow for the appreciation of property values).  The introduction of a 20% RW bucket for standardised banks poses the question whether these banks will have an advantage in targeting the refinancing of seasoned loans with low LVR’s. The IRB banks would seek to retain these customers but they will still be constrained by the 25% average RW mandated by the FSI while the standardised banks face no comparable constraint.

This is unlikely to be an issue in the short term but one of the enduring lessons learned during my time “on the inside” is that banks (not just the big ones) are very good at identifying arbitrages and responding to incentives. It is widely recognised that housing loans have become the largest asset on Australian bank balance sheets (The Royal Commission issued a background paper that cited 42% of assets as at September 2017) but the share was significantly less when I started in banking. There has been a collection of complex drivers at play here (a topic for another post) but the relatively low RW has not harmed the growth of this kind of lending. Consequently, it is dangerous to assume that the status quo will persist if incentives exist to drive a different outcome.

This competitive imbalance could be addressed quite simply if the standardised banks were also subject to a requirement that their average RW was also no lower than 25% (or some alternative floor ratio that adjusted for the differences in exposure and REL noted above).

Another lesson learned “on the inside” is that fixed scalars look simple but are often not. They work fine when the portfolio of assets they are scaling up is stable but will gradually generate a different outcome to what was intended as the composition of the loan book evolves over time. I don’t have an easy solution to this problem but, if you must use them, it helps to recognise the potential for unintended consequence at the start.

Read on below if you have not read the Discussion Paper or want more detail on the revisions APRA has proposed and how these changes are proposed to be reconciled with the FSI recommendation. This is my first real post so feedback would be much appreciated.

Above all, tell me what I am missing … 

Tony

Note: The original version of this post published 22 February 2018 stated that inconsistent measurement of the exposures at default between the standardised and IRB approaches  was not addressed by APRA’s proposed revisions. I believe now that the proposed application of a 100% CCF in the Standardised Approach would in fact address one of the areas of inconsistency. The treatment of Regulatory Expected Loss remains an issue however. The post was revised on 24 February to clarify these points.

APRA’s proposals – in more detail

Good quality loans fully secured by mortgages on occupied residential property (either rented or occupied by the borrower) have been assigned concessionary risk weights (RW) ever since risk weighted capital adequacy ratios were introduced under Basel I (1988). The most concessionary risk weight was initially set at 50% and reduced to 35% in the Basel II Standardised Approach (2006).

APRA currently applies the concessionary 35% RW to standard eligible mortgages with Loan Valuation Ratios (LVR) of 80% or better (or up to 90% LVR if covered by Lender’s Mortgage Insurance) while the best case scenario for a non-standard mortgage is a 50% RW. Progressively higher RW (50/75/100) are applied for higher risk residential mortgages.

Under the Standardised Approach, APRA proposes:

  • The classification of a Standard Eligible Mortgage will distinguish between lowest risk “Owner-occupied P&I” and a higher risk “Other residential mortgages” category which is intended to be conceptually similar to the “material dependence” concept employed by Basel III to distinguish loans where repayment depends materially on the cash flows generated by the property securing the loan
  • 6 RW bands for each of these two types of residential mortgage (compared to 5 bands currently)
  • Standard Eligible Mortgages with lower LVR loans to be assigned lower RW but these loans must also meet defined serviceability, marketability and valuation criteria to qualify for the concessionary RW
  • The higher RW applied to “Other residential mortgages” may take the form of a fixed risk-weight schedule (per the indicative RW in Table 3 of the Discussion Paper) but might also be implemented via a multiplier, applied to the RW for owner-occupied P&I loans, which might vary over time “… depending on prevailing prudential or financial stability objectives or concerns”
  • Relatively lower capital requirements to continue to apply where loans are covered by LMI but its preferred approach is to apply a RW loading to loans with LVR in excess of 80% that are not insured (i.e. the indicative RW in Table 3 assume that LMI covers the high LVR loans)
  • Non-Standard residential mortgages should no longer benefit from any RW concession and be assigned a flat 100% RW irrespective of LVR and LMI

While the IRB requirements impacting residential mortgages are largely unchanged under Basel III, APRA proposes the following changes to the Australian IRB Approach to reflect local requirements and conditions:

  • Increased capital requirements for investment and interest-only exposures; to be implemented via a higher correlation factor for these loans
  • The (currently fixed) correlation factor applied to residential mortgages to be amended to depend on probability of default (PD); reflecting empirical evidence that “… the default risk of lower PD exposures is more dependent on the economic cycle  and can consequently increase at a relatively higher rate in a downturn”
  • A reduction in the minimum Loss Given Default (LGD) from 20% to 10% (subject to APRA approval of the LGD model); in order to facilitate “… better alignment of LGD estimates to key drivers of loss such as LVR and LMI”
  • Capital requirements for non-standard mortgages use the standardised approach; increasing consistency between the IRB an standardised approaches

APRA’s proposals seek to strike a balance between risk sensitivity and simplicity but must also take account of the FSI recommendations that ADI capital levels be unquestionably strong while also narrowing the difference between standardised and IRB RWs for residential mortgages. APRA is undertaking a Quantitative Impact Study (QIS) to better understand the impact of its proposals but the DP flagged that APRA does not expect the changes to correlation factors to meet its objectives for increased capital for residential mortgage exposures.

APRA could just further ramp up the correlation factor to generate the target IRB RW (which I assume continues to be 25%) but the DP notes that this would create undesirable inconsistencies with the correlation factors applied to other asset classes. Consequently, the DP indicates that the target increase in IRB RWA will likely be pursued via

  • A fixed multiplier (scalar) applied to total Credit RWA (i.e. althoughBasel III removes the 1.06 Credit RWA scalar, APRA is considering retaining a scalar with a value yet to be determined); and
  • If necessary, by applying additional specific RWA scalars for residential (and commercial) property.

These scalars will be subject to consultation with the industry and APRA has committed to review the 10.5% CET1 benchmark for unquestionably strong capital should the net result of the proposed revisions result in an overall increase in RWA’s relative to current methodologies.