Capital Adequacy – Page 4 – From the outside

Mortgage Risk Weights – revisited

I post on a range of topics in banking but residential mortgage risk weights is one that seems to generate the most attention. I first posted on the topic back in Sep 2018 and have revisited the topic a few times (Dec 2018, June 2019#1, June 2019#2, and Nov 2019) .

The posts have tended to generate a reasonable number of views but limited direct engagement with the arguments I have advanced. Persistence pays off however because the last post did get some specific and very useful feedback on the points I had raised to argue that the difference in capital requirements between IRB and Standardised Banks was not as big as it was claimed to be.

My posts were a response to the discussion of this topic I observed in the financial press which just focussed on the nominal difference in the risk weights (i.e. 25% versus 39%) without any of the qualifications. I identified 5 problems with the simplistic comparison cited in the popular press and by some regulators:

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

With the benefit of hindsight and the feedback I have received, I would concede that I have probably paid insufficient attention to the disparity between risk weights (RW) at the higher quality end of the mortgage risk spectrum. IRB banks can be seen to writing a substantial share of their loan book at very low RWs (circa 6%) whereas the best case scenario for standardised banks is a 20% RW. The IRB banks are constrained by the requirement that their average RW should be at least 25% and I thought that this RW Floor was sufficient to just focus on the comparison of average RW. I also thought that the revisions to the standardised approach that introduced the 20% RW might make more of a difference. Now I am not so sure. I need to do a bit more work to resolve the question so for the moment I just want to go on record with this being an issue that needs more thought than I have given it to date.

Regarding the other 4 issues that I identified in my first post, I stand by them for the most part. That does not mean I am right of course but I will briefly recap on my arguments, some of the push back that I have received and areas where we may have to just agree to disagree.

Target capital adequacy ratios differ materially. The big IRB banks are targeting CET1 ratios based on the 10.5% Unquestionably Strong Benchmark and will typically have a bit of a buffer over that threshold. Smaller banks like Bendigo and Suncorp appear to operate with much lower CET1 targets (8.5 to 9.0%). This does not completely offset the nominal RW difference (25 versus 39%) but it is material (circa 20% difference) in my opinion so it seem fair to me that the discussion include this fact. I have to say that not all of my correspondents accepted this argument so it seems that we will have to agree to disagree.

You have to include capital deductions. In particular, the IRB banks are required to hold CET1 capital for the shortfall between their loan loss provision and a regulatory capital value called “Regulatory Expected Loss”. There did not appear to be a great awareness of this requirement and a tendency to dismiss it but my understanding is that it can increase the effective capital requirement by 10-12% which corresponds to an effective IRB RW closer to 28% than 25%.

The risk of a mortgage depends on the overall portfolio not the individual loan. My point here has been that small banks will typically be less diversified than big banks and so that justifies a difference in the capital requirements. I have come to recognise that the difference in portfolio risk may be accentuated to the extent that capital requirements applied to standardised banks impede their ability to capture a fair share of the higher quality end of the residential mortgage book. So I think my core point stands but there is more work to do here to fully understand this aspect of the residential mortgage capital requirements. In particular, I would love get more insight into how APRA thought about this issue when it was calibrating the IRB and standardised capital requirements. If they have spelled out their position somewhere, I have not been able to locate it.

You have to include the capital required for Interest Rate Risk in the Banking Book (IRRBB). I did not attempt to quantify how significant this was but simply argued that it was a requirement that IRB banks faced that standardised banks did not and hence it did reduce the benefit of lower RW. The push back I received was that the IRRBB capital requirement was solely a function of IRB banks “punting” their capital and hence completely unrelated to their residential mortgage loans. I doubt that I will resolve this question here and I do concede that the way in which banks choose to invest their capital has an impact on the size of the IRRBB capital requirement. That said, a bank has to hold capital to underwrite the risk in its residential mortgage book and, all other thinks being equal, an IRB bank has to hold more capital for the IRRBB requirement flowing from the capital that it invests on behalf of the residential mortgage book. So it still seems intuitively reasonable to me to make the connection. Other people clearly disagree so we may have to agree to disagree on this aspect.

Summing up, I had never intended to say that there was no difference in capital requirements. My point was simply that the difference is not as big as is claimed and I was yet to see any analysis that considered all of the issues relevant to properly understand what the net difference in capital requirements is. The issue of how to achieve a more level playing field between IRB and Standardised Banks is of course about much more than differences in capital requirements but it is an important question and one that should be based on a firmer set of facts that a simplistic comparison of the 39% standardised versus 25% IRB RW that is regularly thrown around in the discussion of this question.

I hope I have given a fair representation here of the counter arguments people have raised against my original thesis but apologies in advance if I have not. My understanding of the issues has definitely been improved by the challenges posted on the blog so thanks to everyone who took the time to engage.

Tony

Australian banking – “Unquestionably Strong” gets a bit more complicated

Students of the dark art of bank capital adequacy measurement were excited this week by the release of some proposed revisions to APRA’s “Prudential Standard APS 111 Capital Adequacy” (APS 111); i.e. the one which sets out the detailed criteria for measuring an ADI’s Regulatory Capital.

Is anyone still reading? Possibly not, but there is something I think worth noting here if you want to understand what may be happening with Australian bank capital. This is of course only a consultation at this stage but I would be very surprised if the key proposal discussed below is not adopted.

The Short Version

The consultation paper has a number of changes but the one that I want to focus on is the proposal to apply stricter constraints on the amount of equity an ADI invests in banking and insurance subsidiaries.

In order to understand how this impacts the banks, I have to throw in two more pieces of Australian bank capital jargon, specifically Level 1 and Level 2 capital.

Level 1 is the ADI itself on a stand alone basis (note that is a simplification but close enough to the truth for the purposes of this post).
Level 2 is defined in the consultation paper as “The consolidation of the ADI and all its subsidiaries other than non-consolidated subsidiaries; or if the ADI is a subsidiary of a non-operating holding company (NOHC), the consolidation of the immediate parent NOHC and all the immediate parent NOHC’s subsidiaries (including any ADIs and their subsidiaries) other than non-consolidated subsidiaries.”

You can be forgiven for not being familiar with this distinction but the capital ratios typically quoted in any discussion of Australian bank capital strength are the Level 2 measures. The Unquestionably Strong benchmark that dominates the discussion is a Level 2 measure. The changes proposed in this consultation however operate at the Level 1 measurement (the ones that virtually no one currently pays any attention to) and not the Level 2 headline rate.

This has the potential to impact the “Unquestionably Strong” benchmark and I don’t recollect seeing this covered in the consultation paper or any public commentary on the proposal that I have seen to date.

APRA has been quite open about the extent to which these changes are a response to the RBNZ proposal to substantially increase equity requirements for NZ banks.

“This review was prompted in part by recent proposals by the Reserve Bank of New Zealand (RBNZ) to materially increase capital requirements in New Zealand. The RBNZ’s proposals and APRA’s processes are a natural by-product of both regulators working to protect their respective communities from the costs of financial instability and the regulators continue to support each other as these reforms are developed.”

The changes have however been calibrated to maintain the status quo based on the amounts of capital the Australian majors currently have invested in their NZ subsidiaries.

“APRA has calibrated the proposed capital requirements so they are broadly consistent with … the current capital position of the four major Australian banks, in respect of these exposures (i.e. preserving most of the existing capital uplift).”

It follows that any material increase in the capital the majors are required to invest in their NZ subsidiaries (in response to the RBNZ’s proposed requirement) will in turn require that they have to hold commensurately more common equity on a 1:1 basis in the Level 1 ADI to maintain the existing Level 1 capital ratios.

So far as I can see, the Level 2 measure does not require that this extra capital invested in banking subsidiaries be subject to the increased CET1 deductions applied at Level 1. It follows that the Level 2 CET1 ratio will increase but the extent to which a creditor benefits from that added strength will depend on which part of the banking group they sit.

I am not saying this a problem in itself. The RBNZ has the authority to set the capital requirements it deems necessary, Australian bank shareholders can make their own commercial decisions on whether the diluted return on equity meets their requirements and APRA has to respond to protect the interests of the Australian banking system.

I am saying that measuring relative capital adequacy is getting more complicated so you need to pay attention to the detail if this matters to you. In particular, I am drawing attention to the potential for the Level 2 CET1 ratios of the Australian majors to increase in ways that the existing “Unquestionably Strong” benchmark is not calibrated to. I don’t think this matters much for Australian bank depositors who have a very safe super senior position in the Australian loss hierarchy. It probably does matter for creditors who are closer to the sharp end of the loss hierarchy including senior and subordinated bondholders.

To date, the Level 2 capital adequacy ratios have been sufficient to provide a measure of relative capital strength; a higher CET1 ratio equals greater capital strength and that was probably all you needed to know. Going forward, I think you will need to pay closer attention to what is happening at the Level 1 measure to gain a more complete understanding of relative capital strength. The Level 2 measure by itself may not tell you the full story.

The detail

As a rule, APRA’s general capital treatment of equity exposures is to require that they be deducted from CET1 Capital in order to avoid double counting of capital. The existing rules (APS 111) however provides a long-standing variation to this general rule when measuring Level 1 capital adequacy. This variation allows an ADI at Level 1 to risk weight (after first deducting any intangibles component) its equity investments in banking and insurance subsidiaries. The risk weight is 300 percent if the subsidiary is listed or 400 per cent if it is unlisted.

APRA recognises that this improves the L1 ratios by around 100bp versus what would be the case if a full CET1 deduction were applied but is comfortable with that outcome based on current exposure levels.

The RBNZ’s (near certain) move towards higher CET1 requirements however threatens to undermine this status quo and potentially see a greater share of the overall pool of equity in the group migrate from Australia to NZ. APRA recognises of course that the RBNZ can do whatever it deems best for NZ depositors but APRA equally has to ensure that the NZ benefits do not come at the expense of Australian depositors (and other creditors).

To address this issue, APRA is proposing to limit the extent to which an ADI may use debt to fund investments in banking and insurance subsidiaries.

ADIs, at Level 1, will be required to deduct these equity investments from CET1 Capital, but only to the extent the investment in the subsidiary is in excess of 10 per cent of CET1 Capital.
An ADI may risk weight the investment, after deduction of any intangibles component, at 250 per cent to the extent the investment is below this 10 per cent threshold.
The amount of the exposure that is risk weighted would be included as part of the related party limits detailed in the recently finalised APS 222.

As APRA is more concerned about large concentrated exposures, it is proposing to limit the amount of the exposure to an individual subsidiary that can be leveraged to 10 per cent of an ADI’s CET1 Capital. This means capital requirements are increasing for large concentrated exposures, as amounts over the 10 per cent threshold would be required to be met dollar-for-dollar by the ADI parent company.

Summing up

What APRA is proposing to do makes sense to me. We can debate the necessity for the RBNZ to insist on virtually 100% CET1 capital (for the record, I continue to believe that a mix of CET1 and contingent convertible debt is likely to be a more effective source of market discipline). However, once it became clear that the RBNZ was committed to its revised capital requirements, APRA was I think left with no choice but to respond.

What will be interesting from here is to see whether investments of CET1 in NZ banking subsidiaries increase in response to the RBNZ requirement or whether the Australian majors choose to reduce the size of their NZ operations.

If the former (i.e. the majors are required to increase the capital committed to NZ subsidiaries) then we need to keep an eye on how this impacts the Level 2 capital ratios and what happens to the “Unquestionably Strong” CET1 benchmark that currently anchors the capital the Australian majors maintain.

This is a pretty technical area of bank capital so it is possible I am missing something; if so please let me know what it is. Otherwise keep an eye on how the capital adequacy targets of the Australian majors respond to these developments.

Tony (From the Outside)

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

Is the financial system as resilient as policymakers say?

This is the question that Sir Paul Tucker poses in a BIS Working Paper titled “Is the financial system sufficiently resilient: a research programme and policy agenda” (BIS WP790) and answers in the negative. Tucker’s current role as Chair of the Systemic Risk Council and his experience as Deputy Governor at the Bank of England from 2009 to 2013 suggests that, whether you agree or disagree, it is worth reading what he has to say.

Tucker is quick to acknowledge that his assessment is “… intended to jolt the reader” and recognises that he risks “… overstating weaknesses given the huge improvements in the regulatory regime since 2007/08”. The paper sets out why Tucker believes the financial system is not as resilient as claimed, together with his proposed research and policy agenda for achieving a financial system that is sufficiently resilient.

Some of what he writes is familiar ground but three themes I found especially interesting were:

The extent to which recourse by monetary policy to very low interest rates exposes the financial system to a cyclically higher level of systemic risk that should be factored into the resilience target;
The need to formulate what Tucker refers to as a “Money Credit Constitution” ; and
The idea of using “information insensitivity” for certain agreed “safe assets” as the target state of resilience for the system.

Financial stability is of course one of those topics that only true die hard bank capital tragics delve into. The Global Financial Crisis (GFC) demonstrated, however, that financial stability and the resilience of the banking system is also one of those topics that impacts every day life if the technocrats get it wrong. I have made some more detailed notes on the paper here for the technically inclined while this post will attempt (and likely fail) to make the issues raised accessible for those who don’t want to read BIS working papers.

Of the three themes listed above, “information insensitivity” is the one that I would call out in particular. It is admittedly a bit clunky as a catch phrase but I do believe it is worth investing the time to understand what it means and what it implies for how the financial system should be regulated and supervised. I have touched on the concept in a couple of previous posts (here, here, and here) and, as I worked through this post, I also found some interesting overlaps with the idea introduced by the Australian Financial System Inquiry that systemically important banks should be required to be “unquestionably strong”.

How resilient is the financial system?

Tucker’s assessment is that Basel III has made the financial system a lot safer than it was but less resilient than claimed. This is because the original calibration of the higher capital requirements under Basel III did not allow for the way in which any subsequent reduction in interest rates means that monetary policy has less scope to help mitigate economic downturns. All other things being equal, any future stress will have a larger impact on the financial system because monetary policy will have less capacity to stimulate the economy.

We could quibble over details:

The extent to which the capital requirements have been increased by higher Risk Weights applied to exposures (Tucker is more concerned with the extent to which capital requirements get weakened over time in response to industry lobbying)
Why is this not captured in stress testing?
The way in which cyclical buffers could (and arguably should) be used to offset this inherent cyclical risk in the financial system.

But his bigger point sounds intuitively right, all other things being equal, low interest rates mean that central banks will have much less scope to stimulate the economy via monetary policy. It follows that the financial system is systemically riskier at this point in time than historical experience with economic downturns might suggest.

How should we respond (in principle)?

One response is common equity and lots of it. That is what is advocated by some academic commentators , influential former central bankers such as Adair Turner and Mervyn King, and most recently by the RBNZ (with respect to the quantum and the form of capital.

Tucker argues that the increased equity requirements agreed under Basel III are necessary, but not sufficient. His point here is broader than the need to allow for changes in monetary policy discussed above. His concern is what does it take to achieve the desired level of resilience in a financial system that has fractional reserve banking at its core.

”Maintaining a resilient system cannot sanely rely on crushing the probability of distress via prophylactic regulation and supervision: a strategy that confronts the Gods in its technocratic arrogance. Instead, low barriers to entry, credible resolution regimes and crisis-management tools must combine to ensure that the system can keep going through distress. That is different from arguing that equity requirements (E) can be relaxed if resolution plans become sufficiently credible. Rather, it amounts to saying that E would need to be much higher than now if resolution is not credible.”
“Is the Financial system sufficiently resilient: a research programme and policy agenda” BIS WP 790, p 23

That is Tucker’s personal view expressed in the conclusion to the paper but he also advocates that “unelected technicians need to frame the question [of target resilience] in a digestible way for politicians and public debate“. It is especially important that the non-technical people understand the extent to which there may be trade-offs in the choice of how resilient the financial system should be. Is there, for example, a trade-off between resilience and the dynamism of the financial system that drives its capacity to support innovation, competition and growth? Do the resource misallocations associated with credit and property price booms damage the long run growth of the economy? And so on …

Turner offers a first pass at how this problem might be presented to a non-technical audience:

Staying with crisp oversimplification, I think the problem can be put as follows:
• Economists and policymakers do not know much about this. Models and empirics are needed.
• Plausibly, as BIS research suggests, credit and property price booms lead resource misallocation booms? Does that damage long-run growth?
• Even if it does, might those effects be offset by net benefits from greater entrepreneurship during booms?
• Would tough resilience policies constrain capital markets in ways that impede the allocation of resources to risky projects and so growth?
If there is a long-run trade off, then where people are averse to boom-bust ‘cycles’, resilience will be higher and growth lower. By contrast, jurisdictions that care more about growth and dynamism will err on the side of setting the resilience standard too low.
BIS WP790, Page 5

He acknowledges there are no easy answers but asking the right questions is obviously a good place to start.

A “Money-Credit Constitution”

In addition to helping frame the broader parameters of the problem for public debate, central bankers also need to decide what their roles and responsibilities in the financial system should be. Enter the idea of a Money-Credit Constitution (MCC). I have to confess that this was a new bit of jargon for me and I had to do a bit of research to be sure that I knew what Tucker means by it. The concept digs down into the technical aspects of central banking but it also highlights the extent to which unelected technocrats have been delegated a great deal of power by the electorate. I interpret Tucker’s use of the term “constitution”as an allusion to the need for the terms on which this power is exercised to be defined and more broadly understood.

A Money-Credit Constitution defined:

“By that I mean rules of the game for both banking and central banking designed to ensure broad monetary stability, understood as having two components: stability in the value of central bank money in terms of goods and services, and also stability of private-banking-system deposit money in terms of central bank money.”
Chapter 1: How can central banks deliver credible commitment and be “Emergency Institutions”? by John Tucker in “Central Bank Governance and Oversight Reform, edited by Cochrane and Taylor (2016)

The jargon initially obscured the idea (for me at least) but some practical examples helped clarify what he was getting at. Tucker defines the 19th and early 20th century MCC as comprising; the Gold Standard, reserve requirements for private banks and the Lender of Last Resort (LOLR) function provided by the central bank. The rules of the game (or MCC) have of course evolved over time. In the two to three decades preceding the 2008 GFC, the rules of the game incorporated central bank independence, inflation targeting and a belief in market efficiency/discipline. Key elements of that consensus were found to be woefully inadequate and we are in the process of building a new set of rules.

Tucker proposes that a MCC that is fit for the purpose of achieving an efficient and resilient financial system should have five key components:

– a target for inflation (or some other nominal magnitude);
– a requirement for banking intermediaries to hold reserves (or assets readily exchanged for reserves) that increases with a firm’s leverage and/or the degree of liquidity mismatch between its assets and liabilities;
– a liquidity-reinsurance regime for fundamentally solvent banking intermediaries;
– a resolution regime for bankrupt banks and other financial firms; and
– constraints on how far the central bank is free to pursue its mandate and structure its balance sheet, given that a monetary authority by definition has latent fiscal capabilities.
BIS WP, Page 9

In one sense, the chosen resilience strategy for the financial system is simply determined by the combination of the capital and liquidity requirements imposed on private banks. We are using the term capital here in its broadest sense to incorporate not just common equity but also the various forms of hybrid equity and subordinated debt that can be converted into equity without disrupting the financial system.

But Tucker argues that there is a bigger question of strategy that must be addressed; that is

“whether to place the regime’s weight on regulatory requirements that impose intrinsic resilience on bank balance sheets or on credible crisis management that delivers safety ex post. It is a choice with very different implications for transparency.”
BIS WP 790; Page 11

Two alternative strategies for achieving a target state of financial system resilience

Strategy 1: Crisis prevention (or mitigation at least)

The first strategy is essentially an extension of what we have already been doing for some time; a combination of capital and liquidity requirements that limits the risk of financial crisis to some pre-determined acceptable level.

“… authorities set a regulatory minimum they think will be adequate in most circumstances and supervise intermediaries to check whether they are exposed to outsized risks.
BIS WP 790, Page 11

Capital and liquidity requirements were increased under Basel III but there was nothing fundamentally new in this part of the Basel III package. Tucker argues that the standard of resilience adopted should be explicit rather than implicit but he still doubts that this strategy is robust. His primary concern seems to be the risk that the standard of resilience is gradually diluted by a series of small concessions that only the technocrats understand.

“How did we know that firms are really satisfying the standard: is it enough that they say so? And how do we know that the authorities themselves have not quietly diluted or abandoned the standard?”
BIS WP 790; Page 11

Tucker has ideas for how this risk of regulatory capture might be controlled:

 each year central bank staff (not policymakers) should publish a complete statement of all relaxations and tightenings of regulatory and supervisory policy (including in stress testing models, rules, idiosyncratic requirements, and so on)
 the integrity of such assessments should be subject to external audit of some kind (possibly by the central auditor for the state).
BIS WP 790, Page 12

… but this is still a second best approach in his assessment; he argues that we can do better and the idea of making certain assets “informationally insensitive” is the organising principle driving the alternative strategies he lays out.

Strategy 2: Making assets informationally insensitive via crisis-management regimes

Tucker identifies two approaches to crisis management both based around the objective of ensuring that the value of certain agreed liabilities, issued by a defined and pre-determined set of financial intermediaries, is insensitive to information about the financial condition of these intermediaries:

Strategy 2a: Integrate LOLR with liquidity policy.

Central bankers, as the suppliers of emergency liquidity assistance, could make short term liabilities informationally insensitive by requiring banks to hold reserves or eligible collateral against all runnable liabilities. Banks would be required to cover “x”% of short term liabilities with reserves and/or eligible collateral. The key policy choices then become

The definition of which short term liabilities drive the liquidity requirement;
The instruments that would be eligible collateral for liquidity assistance; and
The level of haircuts set by central banks against eligible collateral

What Tucker is outlining here is a variation on a proposal that Mervyn King set out in his book “The End of Alchemy” which I covered in a previous post. These haircuts operate broadly analogously to the existing risk-weighted equity requirements. Given the focus on emergency requirements, they would be based on stress testing and incorporate systemic risk surcharges.

Tucker is not however completely convinced by this approach:

“… a policy of completely covering short-term labilities with central bank-eligible assets would leave uninsured short-term liabilities safe only when a bank was sound. They would not be safe when a bank was fundamentally unsound.
That is because central banks should not (and in many jurisdictions cannot legally) lend to banks that have negative net assets (since LOLR assistance would allow some short-term creditors to escape whole at the expense of equally ranked longer-term creditors). This is the MCC’s financial-stability counterpart to the “no monetary financing” precept for price stability.
Since only insured-deposit liabilities, not covered but uninsured liabilities, are then safe ex post, uninsured liability holders have incentives to run before the shutters come down, making their claims information sensitive after all.
More generally, the lower E, the more frequently banks will fail when the central bank is, perforce, on the sidelines. This would appear to take us back, then, to the regulation and supervision of capital adequacy, but in a way that helps to keep our minds on delivering safety ex post and so information insensitivity ex ante.”
BIS WP 790, Page 14

Strategy 2b: Resolution policy – Making operational liabilities informationally insensitive via structure

Tucker argues that the objective of resolution policy can be interpreted as making the operational liabilities of banks, dealers and other intermediaries “informationally insensitive”. He defines “operational liabilities” as “… those liabilities that are intrinsically bound to the provision of a service (eg large deposit balances, derivative transactions) or the receipt of a service (eg trade creditors) rather than liabilities that reflect a purely risk-based financial investment by the creditor and a source of funding/leverage for the bank or dealer”

Tucker proposes that this separation of operational liabilities from purely financial liabilities can be “… made feasible through a combination of bail-in powers for the authorities and, crucially, restructuring large and complex financial groups to have pure holding companies that issue the bonds to be bailed-in” (emphasis added).

Tucker sets out his argument for structural subordination as follows.

“…provided that the ailing operating companies (opcos) can be recapitalised through a conversion of debt issued to holdco …., the opcos never default and so do not go into a bankruptcy or resolution process. While there might be run once the cause of the distress is revealed, the central bank can lend to the recapitalised opco …
This turns on creditors and counterparties of opcos caring only about the sufficiency of the bonds issued to the holdco; they do not especially care about any subsequent resolution of the holding company. That is not achieved, however, where the bonds to be bailed in … are not structurally subordinated. In that respect, some major jurisdictions seem to have fallen short:
 Many European countries have opted not to adopt structural subordination, but instead have gone for statutory subordination (eg Germany) or contractual subordination (eg France).
 In consequence, a failing opco will go into resolution
 This entails uncertainty for opco liability holders given the risk of legal challenge etc
 Therefore, opco liabilities under those regimes will not be as informationally insensitive as would have been possible.
BIS WP 790, Page 15

While structural subordination is Tucker’s preferred approach, his main point is that the solution adopted should render operational liabilities informationally insensitive:

“….the choice between structural, statutory and contractual subordination should be seen not narrowly in terms of simply being able to write down and/or convert deeply subordinated debt into equity, but rather more broadly in terms of rendering the liabilities of operating intermediaries informationally insensitive. The information that investors and creditors need is not the minutiae of the banking business but the corporate finance structure that enables resolution without opcos formally defaulting or going into a resolution process themselves
BIS WP 790 , Pages 15-16

If jurisdictions choose to stick with contractual or statutory subordination, Tucker proposes that they need to pay close attention to the creditor hierarchy, especially where the resolution process is constrained by the requirement that no creditor should be worse off than would have been the case in bankruptcy. Any areas of ambiguity should be clarified ex ante and, if necessary, the granularity of the creditor hierarchy expanded to ensure that the treatment of creditors in resolution is what is fair, expected and intended.

Tucker sums up the policy implications of this part of his paper as follows ...

“The policy conclusion of this part of the discussion, then, is that in order to deliver information insensitivity for some of the liabilities of operating banks and dealers, policymakers should:
a) move towards requiring that all short-term liabilities be covered by assets eligible at the central bank; and, given that that alone cannot banish bankruptcy,
b) be more prescriptive about corporate structures and creditor hierarchies since they matter hugely in bankruptcy and resolution.”
BIS WP 790, Page 16

Summing up …

Tucker positions his paper as “… a plea to policymakers to work with researchers to re-examine whether enough has been done to make the financial system resilient“.
His position is that “… the financial system is much more resilient than before the crisis but … less resilient than claimed by policymakers”
Tucker’s assessment “… is partly due to shifts in the macroeconomic environment” which reduce the capacity of monetary and fiscal policy stimulus but also an in principle view that “maintaining a resilient system cannot sanely rely on crushing the probability of distress via prophylactic regulation and supervision: a strategy that confronts the Gods in its technocratic arrogance“.
Tucker argues that the desired degree of resilience is more likely to be found in a combination of “… low barriers to entry, credible resolution regimes and crisis management tools …[that] … ensure the system can keep going through distress”.
Tucker also advocates putting the central insights of some theoretical work on “informational insensitivity” to practical use in the following way:
- move towards requiring all banking-type intermediaries to cover all short-term liabilities with assets eligible for discount at the Window
- insist upon structural subordination of bailinable bonds so that the liabilities of operating subsidiaries are more nearly informationally insensitive
- be more prescriptive about the permitted creditor hierarchy of operating intermediaries
- establish frameworks for overseeing and regulating collateralised money market, with more active use made of setting minimum haircut requirements to ensure that widely used money market instruments are safe in nearly all circumstancesarticulating restrictive principles for market-maker of last resort operations
Given the massive costs (economic, social, cultural) associated with financial crises, err on the side of maintaining resilience
To the extent that financial resilience continues to rely on the regulation and supervision of capital adequacy, ensure transparency regarding the target level of resilience and the extent to which discretionary policy actions impact that level of resilience

I am deeply touched if you actually read this far. The topic of crisis management and resolution capability is irredeemably technical but also important to get right.

Tony

Deposit insurance and moral hazard

Depositors tend to be a protected species

It is generally agreed that bank deposits have a privileged position in the financial system. There are exceptions to the rule such as NZ which, not only eschews deposit insurance, but also the practice of granting deposits a preferred (or super senior) claim on the assets of the bank. NZ also has a unique approach to bank resolution which clearly includes imposing losses on bank deposits as part of the recapitalisation process. Deposit insurance is under review in NZ but it is less clear if that review contemplates revisiting the question of deposit preference.

The more common practice is for deposits to rank at, or near, the top of the queue in their claim on the assets of the issuing bank. This preferred claim is often supported by some form of limited deposit insurance (increasingly so post the Global Financial Crisis of 2008). An assessment of the full benefit has to consider the cost of providing the payment infrastructure that bank depositors require but the issuing bank benefits from the capacity to raise funds at relatively low interest rates. The capacity to raise funding in the form of deposits also tends to mean that the issuing banks will be heavily regulated which adds another layer of cost.

The question is whether depositors should be protected

I am aware of two main arguments for protecting depositors:

One is to protect the savings of financially unsophisticated individuals and small businesses.
The other major benefit relates to the short-term, on-demand, nature of deposits that makes them convenient for settling transactions but can also lead to a ‘bank run’.

The fact is that retail depositors are simply not well equipped to evaluate the solvency and liquidity of a bank. Given that even the professionals can fail to detect problems in banks, it is not clear why people who will tend to lie at the unsophisticated end of the spectrum should be expected to do any better. However, the unsophisticated investor argument by itself is probably not sufficient. We allow these individuals to invest in the shares of banks and other risky investments so what is special about deposits.

The more fundamental issue is that, by virtue of the way in which they function as a form of money, bank deposits should not be analysed as “investments”. To function as money the par value of bank deposits must be unquestioned and effectively a matter of faith or trust. Deposit insurance and deposit preference are the tools we use to underwrite the safety and liquidity of bank deposits and this is essential if bank deposits are to function as money. We know the economy needs money to facilitate economic activity so if bank deposits don’t perform this function then you need something else that does. Whatever the alternative form of money decided on, you are still left with the core issue of how to make it safe and liquid.

Quote
“The capacity of a financial instrument like a bank deposit to be accepted and used as money depends on the ability of uninformed agents to trade it without fear of loss; i.e. the extent to which the value of the instrument is insulated from any adverse information about the counterparty”
Gary Gorton and George Pennacchi “Financial Intermediaries and Liquidity Creation”

I recognise that fintech solutions are increasingly offering alternative payment mechanisms that offer some of the functions of money but to date these still ultimately rely on a bank with a settlement account at the central bank to function. This post on Alphaville is worth reading if you are interested in this area of financial innovation. The short version is that fintechs have not been able to create new money in the way banks do but this might be changing.

But what about moral hazard?

There is an argument that depositors should not be a protected class because insulation from risk creates moral hazard.

While government deposit insurance has proven very successful in protecting banks from runs, it does so at a cost because it leads to moral hazard (Santos, 2000, p. 8). By offering a guarantee that depositors are not subject to loss, the provider of deposit insurance bears the risk that they would otherwise have borne.
According to Dr Sam Wylie (2009, p. 7) from the Melbourne Business School:
“The Government eliminates the adverse selection problem of depositors by insuring them against default by the bank. In doing so the Government creates a moral hazard problem for itself. The deposit insurance gives banks an incentive to make higher risk loans that have commensurately higher interest payments. Why?, because they are then betting with taxpayer’s money. If the riskier loans are repaid the owners of the bank get the benefit. If not, and the bank’s assets cannot cover liabilities, then the Government must make up the shortfall”
Reconciling Prudential Regulation with Competition, Pegasus Economics, May 2019 (p17)

A financial system that creates moral hazard is clearly undesirable but, for the reasons set out above, it is less clear to me that bank depositors are the right set of stakeholders to take on the responsibility of imposing market discipline on banks. There is a very real problem here but requiring depositors to take on this task is not the answer.

The paper by Gorton and Pennacchi that I referred to above notes that there is a variety of ways to make bank deposits liquid (i.e. insensitive to adverse information about the bank) but they argue for solutions where depositors have a sufficiently deep and senior claim on the assets of the bank that any volatility in their value is of no concern. This of course is what deposit insurance and giving deposits a preferred claim in the bank loss hierarchy does. Combining deposit insurance with a preferred claim on a bank’s assets also means that the government can underwrite deposit insurance with very little risk of loss.

It is also important I think to recognise that deposit preference moves the risk to other parts of the balance sheet that are arguably better suited to the task of exercising market discipline. The quote above from Pegasus Economics focussed on deposit insurance and I think has a fair point if the effect is simply to move risk from depositors to the government. That is part of the reason why I think that deposit preference, combined with how the deposit insurance is funded, are also key elements of the answer.

Designing a banking system that addresses the role of bank deposits as the primary form of money without the moral hazard problem

I have argued that the discussion of moral hazard is much more productive when the risk of failure is directed at stakeholders who have the expertise to monitor bank balance sheets, the capacity to absorb the risk and who are compensated for undertaking this responsibility. If depositors are not well suited to the market discipline task then who should bear the responsibility?

Senior unsecured debt
Non preferred senior debt (Tier 3 capital?)
Subordinated debt (i.e. Tier 2 capital)
Additional Tier 1 (AT1)
Common Equity Tier 1 (CET1)

There is a tension between liquidity and risk. Any security that is risky may be liquid during normal market conditions but this “liquidity” cannot be relied on under adverse conditions. Senior debt can in principle be a risky asset but most big banks will also aim to be able to issue senior debt on the best terms they can achieve to maximise liquidity. In practice, this means that big banks will probably aim for a Long Term Senior Debt Rating that is safely above the “investment grade” threshold. Investment grade ratings offer not just the capacity top issue at relatively low credit spreads but also, and possibly more importantly, access to a deeper and more reliable pool of funding.

Cheaper funding is nice to have but reliable access to funding is a life and death issue for banks when they have to continually roll over maturing debt to keep the wheels of their business turning. This is also the space where banks can access the pools of really long term funding that are essential to meet the liquidity and long term funding requirements that have been introduced under Basel III.

The best source of market discipline probably lies in the space between senior debt and common equity

I imagine that not every one will agree with me on this but I do not see common equity as a great source of market discipline on banks. Common equity is clearly a risky asset but the fact that shareholders benefit from taking risk is also a reason why they are inclined to give greater weight to the upside than to the downside when considering risk reward choices. As a consequence, I am not a fan of the “big equity” approach to bank capital requirements.

In my view, the best place to look for market discipline and the control of moral hazard in banking lies in securities that fill the gap between senior unsecured debt and common equity; i.e. non-preferred senior debt, subordinated debt and Additional Tier 1. I also see value in having multiple layers of loss absorption as opposed to one big homogeneous layer of loss absorption. This is partly because it can be more cost effective to find different groups of investors with different risk appetites. Possibly more important is that multiple layers offer both the banks and supervisors more flexibility in the size and impact of the way these instruments are used to recapitalise the bank.

Summing up …

I have held off putting this post up because I wanted the time to think through the issues and ensure (to the best of my ability) that I was not missing something. There remains the very real possibility that I am still missing something. That said, I do believe that understanding the role that bank deposits play as the primary form of money is fundamental to any complete discussion of the questions of deposit insurance, deposit preference and moral hazard in banking.

Tony

Automatic stabilisers in banking capital | VOX, CEPR Policy Portal

I am in favour of cyclical capital buffers but not the kind the BCBS has developed.

I have attached a link to a post by Charles Goodhart and Dirk Schoenmaker which highlights the problems with the BCBS Counter Cyclical Capital Buffer (CCyB) and proposes an alternative more rules based approach.

While banking is procyclical, the capital framework is largely static. The countercyclical capital buffer is discretionary, with potential danger of inaction, and is also limited in scale. This column proposes an expanded capital conservation buffer, which would act as an automatic stabiliser. This could incorporated in the next Basel review and the upcoming Solvency II review.

I have my own preferred alternative approach to the cyclical buffer problem but I agree very much with their critique of the CCyB.

Their post on this question is not long but worth reading.

— Read on voxeu.org/article/automatic-stabilisers-banking-capital

Tony

A BCBS review of the costs and benefits of higher bank capital requirements

The economic rational for higher bank capital requirements that have been implemented under Basel III is built to a large extent on an analytical model developed by the BCBS that was published in a study released in 2010. The BCBS has just (June 2019) released a paper by one of its working groups which reviews the original analysis in the light of subsequent studies into the optimal capital question. The 2019 Review concludes that the higher capital requirements recommended by the original study have been supported by these subsequent studies and, if anything, the optimal level of capital may be higher than that identified in the original analysis.

Consistent with the Basel Committee’s original assessment, this paper finds that the net macroeconomic benefits of capital requirements are positive over a wide range of capital levels. Under certain assumptions, the literature finds that the net benefits of higher capital requirements may have been understated in the original Committee assessment. Put differently, the range of estimates for the theoretically-optimal level of capital requirements … is likely either similar or higher than was originally estimated by the Basel Committee.
The costs and benefits of bank capital – a review of the literature; BCBS Working Paper (June 2019)

For anyone who is interested in really understanding this question as opposed to simply looking for evidence to support a preconceived bias or vested interest, it is worth digging a bit deeper into what the paper says. A good place to start is Table 1 from the 2019 Review (copied below) which compares the assumptions, estimates and conclusions of these studies:

Pay attention to the fine print

All of these studies share a common analytical model which measures Net benefits as a function of:

Reduced Crisis Probability x Crisis Cost – Output Drag (loan spreads).

So the extent of any net benefit depends on the extent to which:

More capital actually reduces the probability of a crisis and/or its economic impact,
The economic impact of a financial crisis is a permanent or temporary adjustment to the long term growth trajectory of the economy – a permanent effect supports the case for higher capital, and
The cost of bank debt declines in response to higher capital – in technical terms the extent of the Modigliani Miller (MM) offset, with a larger offset supporting the case for higher capital.

The authors of the 2019 Review also acknowledge that interpretation of the results of the studies is complicated by the fact that different studies use different measures of capital adequacy. Some of the studies provide optimal capital estimates in risk weighted ratios, others in leverage ratios. The authors of the 2019 Review have attempted to convert the leverage ratios to a risk weighted equivalent but that process will inevitably be an imperfect science. The definition of capital also differs (TCE, Tier 1 & CET1).

The authors acknowledge that full standardisation of capital ratios is very complex and lies beyond the scope of their review and nominate this as an area where further research would be beneficial. In the interim (and at the risk of stating the obvious) the results and conclusions of this 2019 Review and the individual studies it references should be used with care. The studies dating from 2017, for example, seem to support a higher value for the optimal capital range compared to the 2010 benchmark. The problem is that it is not clear how these higher nominal ratio results should be interpreted in the light of increases in capital deductions and average risk weights such as we have seen play out in Australia.

The remainder of this post will attempt to dig a bit deeper into some of the components of the net benefit model employed in these types of studies.

Stability benefits – reduced probability of a crisis

The original 2010 BCBS study concluded that increasing Tangible Common Equity from 7% to 10% would reduce the probability of a financial crisis by 1.6 percentage points.

The general principle is that a financial crisis is a special class of economic downturn in which the severity and duration is exacerbated by a collapse in confidence in the banking system due to widespread doubts about the solvency of one or more banks which results in a contraction in the supply of credit.

It follows that higher capital reduces the odds that any given level of loss can threaten the actual or perceived solvency of the banking system. So far so good, but I think it is helpful at this point to distinguish the core losses that flow from the underlying problem (e.g. poor credit origination or risk management) versus the added losses that arise when credit supply freezes in response to concerns about the solvency or liquidity of the banking system.

Higher capital (and liquidity) requirements can help to mitigate the risk of those second round losses but they do not in any way reduce the economic costs of the initial poor lending or risk management. The studies however seem to use the total losses experienced in historical financial crises to calculate the net benefit rather than specific output losses that can be attributed to credit shortages and any related drop in employment and/or the confidence of business and consumers. That poses the risk that the studies may be over estimating the potential benefits of higher capital.

This is not saying that higher capital requirements are a waste of time but the modelling of optimal capital requirements must still understand the limitations of what capital can and cannot change. There is, for example, evidence that macro prudential policy tools may be more effective tools for managing the risk of systemic failures of credit risk management as opposed to relying on the market discipline of equity investors being required to commit more “skin in the game“.

Cost of a banking crisis

The 2019 Review notes that

“recent refinements associated with identifying crises is promising. Such refinements have the potential to affect estimates of the short- and long-run costs of crises as well as our understanding of how pre-crisis financial conditions affect these costs. Moreover, the identification of crises is important for estimating the relationship between banking system capitalisation and the probability of a crisis, which is likely to depend on real drivers (eg changes in employment) as well as financial drivers (eg bank capital).

We considered above the possibility that there may be fundamental limitations on the extent to which capital alone can impact the probability, severity and duration of a financial crisis. The 2019 Review also acknowledges that there is an ongoing debate, far from settled, regarding the extent to which a financial crisis has a permanent or temporary effect on the long run growth trajectory of an economy. This seemingly technical point has a very significant impact on the point at which these studies conclude that the costs of higher capital outweigh the benefits.

The high range estimates of the optimal capital requirement in these studies typically assume that the impacts are permanent. This is big topic in itself but Michael Redell’s blog did a post that goes into this question in some detail and is worth reading.

Banking funding costs – the MM offset

The original BCBS study assumed zero offset (i.e. no decline in lending rates in response to deleveraging). This assumption increase the modelled impact of higher capital and, all other things equal, reduces the optimal capital level. The later studies noted in the BCBS 2019 Review have tended to assume higher levels of MM offset and the 2019 Review concludes that the “… assumption of a zero offset likely overstated the costs of higher capital nonbank loan rates”. For the time being the 2019 Review proposes that “a fair reading of the literature would suggest the middle of the 0 and 100% extremes” and calls for more research to “… help ground the Modigliani-Miller offset used in estimating optimal bank capital ratios”.

Employing a higher MM offset supports a higher optimal capital ratio but I am not convinced that even the 50% “split the difference” compromise is the right call. I am not disputing the general principle that risk and leverage are related. My concern is that the application of this general principle does not recognise the way in which some distinguishing features of bank balance sheets impact bank financing costs and the risk reward equations faced by different groups of bank stakeholders. I have done a few posts previously (here and here) that explore this question in more depth.

Bottom line – the BCBS itself is well aware of most of the issues with optimal capital studies discussed in this post – so be wary of anyone making definitive statements about what these studies tell us.

The above conclusion is however subject to a number of important considerations. First, estimates of optimal capital are sensitive to a number of assumptions and design choices. For example, the literature differs in judgments made about the permanence of crisis effects as well as assumptions about the efficacy of post crisis reforms – such as liquidity regulations and bank resolution regimes – in reducing the probability and costs of future banking crisis. In some cases, these judgements can offset the upward tendency in the range of optimal capital.
Second, differences in (net) benefit estimates can reflect different conditioning assumptions such as starting levels of capital or default thresholds (the capital ratio at which firms are assumed to fail) when estimating the impact of capital in reducing crisis probabilities.2
Finally, the estimates are based on capital ratios that are measured in different units. For example, some studies provide optimal capital estimates in risk-weighted ratios, others in leverage ratios. And, across the risk-weighted ratio estimates, the definition of capital and risk-weighted assets (RWAs) can also differ (eg tangible common equity (TCE) or Tier 1 or common equity tier 1 (CET1) capital; Basel II RWAs vs Basel III measures of RWAs). A full standardisation of the different estimates across studies to allow for all of these considerations is not possible on the basis of the information available and lies beyond the scope of this paper.
This paper also suggests a set of issues which warrant further monitoring and research. This includes the link between capital and the cost and probability of crises, accounting for the effects of liquidity regulations, resolution regimes and counter-cyclical capital buffers, and the impact of regulation on loan quantities.
The costs and benefits of bank capital – a review of the literature; BCBS Working Paper (June 2019)

Summing up

I would recommend this 2019 Literature Review to anyone interested in the question of how to determine the optimal capital requirements for banks. The topic is complex and important and also one where I am acutely aware that I may be missing something. I repeat the warning above about anyone (including me) making definitive statements based on these types of studies.

That said, the Review does appear to offer support for the steps the BCBS has taken thus far to increase capital and liquidity requirements. There are also elements of the paper that might be used to support the argument that bank capital requirements should be higher again. This is the area where I think the fine print offers a more nuanced perspective.

Tony

Bank funding costs and capital structure

Here is another paper for anyone interested in the optimal bank capital structure debate. It is a Bank of England Staff Working Paper titled “Bank funding costs and capital structure” by Andrew Gimber and Aniruddha Rajan.

The authors summarise their paper as follows:

“If bail-in is credible, risk premia on bank securities should decrease as funding sources junior to and alongside them in the creditor hierarchy increase. Other things equal, we find that when banks have more equity and less subordinated debt they have lower risk premia on both. When banks have more subordinated and less senior unsecured debt, senior unsecured risk premia are lower. For percentage point changes to an average balance sheet, these reductions would offset about two thirds of the higher cost of equity relative to subordinated debt and one third of the spread between subordinated and senior unsecured debt.”
Abstract

The paper adds support to the argument 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 on equity. In the jargon of the corporate finance wonks, the paper supports a Modigliani Miller (MM) offset.

I need to dig a bit deeper into the results but I am struggling with the finding that increasing the level of subordinated debt at the expense of senior debt results in a reduction in the cost of senior debt. In the interests of full disclosure, I recognise that this may simply reflect the fact that my experience and knowledge base is mostly limited to the Australian and New Zealand banking systems but here goes. As always, it is also possible that I am simply missing something.

The problem for me in these results

We are not debating here the principle that risk (and hence required return) increases as you move through the loss hierarchy. This is a common challenge thrown out at anyone who questions the thesis that risk should decline as you reduce leverage. My concern is that MM did not anticipate a financing structure in which the risk of certain liabilities is mitigated by the existence of an assumption that the public sector will support any bank that is deemed Too Big To Fail (TBTF).

I am not seeking to defend the right of banks to benefit from this implied subsidy. I fully support the efforts being made to eliminate this market distortion. However, so far as I can determine, the reality is that increasing the level of subordinated debt and/or equity may reduce the value of the implied TBTF assumption but senior debt itself does not seem to be any less risky so far as senior debt investors are concerned. So why should they adjust their required return?

This seems to be what we are observing in the response of the debt ratings of the major Australian banks to proposals that they be required to maintain increased levels of subordinated debt to comply with Basel III’s Total Loss Absorbing Capital (TLAC) requirement.

My second concern is not specific to the Bank of England paper but worth mentioning since we are on the topic. One of the MM predictions tested in this study is that “the risk premium on a funding source should fall as that funding source expands at the expense of a more senior one” with the study finding evidence that this is true. This proposition (now supported by another study with empirical data) is often used to argue that it really does not matter how much equity a bank is required to hold because the cost of equity will decline to compensate (the “Big Equity” argument).

What is missing, I think, is any consideration of what is the lower boundary for the return that an equity investor requires to even consider taking the junior position in the financing structure in what is ultimately one of the most cyclically exposed areas of an economy. My last post looked at a study of the returns on both risky and safe assets over a period of 145 years which suggested that risky assets have on average generated a real return of circa 7% p.a.. When you factor in an allowance for inflation you are looking at something in the range of 9%-10% p.a. In addition, there are a range of factors that suggest a bank should be looking to target a Return on Equity of at least 2%-3% over the average “through the cycle” expected return. This includes the way that loan losses are accounted for in the benign part of the cycle and I don’t think that IFRS9 is going to change this.

This is a topic I plan to explore in greater detail in a future post. For the moment, the main point is that there has to be a lower boundary to how much the cost of equity can decline to in response to changes in capital structure but this seems to be largely absent from the Big Equity debate.

I have added a bit of background below for anyone who is not familiar with the detail of how a bank financing structure tends to be more complicated than that of a typical non-financial company.

Tell me what I am missing …

Tony

Appendix: A bit of background for those new to this debate

The extent of this MM offset is one of the more contentious issues in finance that has generated a long and heated debate stretching back over more than half a century. Both sides of the debate agree that there is a hierarchy of risk in a company financing structure. Common equity is unambiguously at the high end of this risk hierarchy and hence should expect to earn the highest return. Layers in the hierarchy, and hence the relative protection from solvency risk, are introduced by creating levels of seniority/subordination amongst the various funding sources.

An industrial company could just have debt and equity in which case the MM offset is much easier to analyse (though still contentious). Bank financing structures, in contrast, introduce a variety of issues that render the debate even more complicated and contentious:

Prudential capital requirements introduce at least three layers of subordination/seniority via the distinction between minimum capital requirements for Common Equity Tier 1, Additional Tier 1 and Tier 2 capital
The transition to a “bail-in” regime potentially introduces another level of subordination/seniority in the form of an additional requirement for certain (typically large and systemically important) banks to hold Non-Preferred Senior debt (or something functionally equivalent)
Next comes senior unsecured debt that is one of the workhorses of the bank financing structure (which in turn may be short or long term)
In certain cases a bank may also issue covered bonds which are secured against a pool of assets (to keep things simple, I will skip over securitisation financing)
Banks are also distinguished by their capacity to borrow money in the form of bank deposits which also serve as a means of payment in the economy (and hence as a form of money)
Bank deposits often have the benefit of deposit insurance and/or a preferred super senior claim on the assets of the bank

Apart from the formal protections afforded by the seniority of their claim, certain liabilities (typically the senior unsecured) can also benefit from an implied assumption that the government will likely bail a bank out because it is Too Big To Fail (TBTF). Eliminating this implied subsidy is a key objective of the changes to bank capital requirements being progressively implemented under Basel III.

Until this process is complete, and the implied balance sheet value of being considered TBTF is eliminated, the response of bank funding costs to changes in leverage will not always follow the simple script defined by the MM capital irrelevancy thesis.

Mortgage risk weights fact check revisited – again

The somewhat arcane topic of mortgage risk weights is back in the news. It gets popular attention to the extent they impact the ability of small banks subject to standardised risk weights to compete with bigger banks which are endorsed to use the more risk sensitive version based on the Internal Ratings Based (IRB) approach. APRA released a Discussion Paper (DP) in February 2018 titled “Revisions to the capital framework for authorised deposit-taking institutions”. There are reports that APRA is close to finalising these revisions and that this will address the competitive disadvantage that small banks suffer under the current regulation.

This sounds like a pretty simple good news story – a victory for borrowers and the smaller banks – and my response to the discussion paper when it was released was that there was a lot to like in what APRA proposed to do. I suspect however that it is a bit more complicated than the story you read in the press.

The difference in capital requirements is overstated

Let’s start with the claimed extent of the competitive disadvantage under current rules. The ACCC’s Final Report on its “Residential Mortgage Price Inquiry” described the challenge with APRA’s current regulatory capital requirements as follows:

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

You could be forgiven for concluding that this differential (small banks apparently required to hold 56% more capital for the same risk) is outrageous and unfair.

Just comparing risk weights is less than half the story

I am very much in favour of a level playing field and, as stated above, I am mostly in favour of the changes to mortgage risk weights APRA outlined in its discussion paper but I also like fact based debates.

While the risk weights for big banks are certainly lower on average than those required of small banks, the difference in capital requirements is not as large as the comparison of risk weights suggests. To understand why the simple comparison of risk weights is misleading, it will be helpful to start with a quick primer on bank capital requirements.

The topic can be hugely complex but, reduced to its essence, there are three elements that drive the amount of capital a bank holds:

The risk weights applied to its assets
The target capital ratio applied to those risk weighted assets
Any capital deductions required when calculating the capital ratio

I have looked at this question a couple of times (most recently here) and identified a number of problems with the story that the higher risk weights applied to residential mortgages originated by small bank places them at a severe competitive disadvantage:

Target capital ratios – The target capital adequacy ratios applied to their higher standardised risk weighted assets are in some cases lower than the IRB banks and higher in others (i.e. risk weights alone do not determine how much capital a bank is required to hold).

Portfolio risk – The risk of a mortgage depends on the portfolio not the individual loan. The statement that a loan is the same risk irrespective of whether it is written by a big bank or small bank sounds intuitively logical but is not correct. The risk of a loan can only be understood when it is considered as part of the portfolio the bank holds. All other things being equal, small banks will typically be less diversified and hence riskier than a big bank.

Capital deductions – You also have to include capital deductions and the big banks are required to hold capital for a capital deduction linked to the difference between their loan loss provisions and a regulatory capital value called “Regulatory Expected Loss”. The exact amount varies from bank to bank but I believe it increases the effective capital requirement by 10-12% (i.e. an effective RW closer to 28% for the IRB banks).

IRRBB capital requirement – IRB banks must hold capital for Interest Rate Risk in the Banking Book (IRRBB) while the small standardised banks do not face an explicit requirement for this risk. I don’t have sufficient data to assess how significant this is, but intuitively I would expect that the capital that the major banks are required to hold for IRRBB will further narrow the effective difference between the risk weights applied to residential mortgages.

How much does reducing the risk weight differential impact competition in the residential mortgage market?

None of the above is meant to suggest that the small banks operating under the standardised approach don’t have a case for getting a lower risk weight for their higher quality lower risk loans. If the news reports are right then it seems that this is being addressed and that the gap will be narrower. However, it is important to remember that:

The capital requirement that the IRB banks are required to maintain is materially higher than a simplistic application of the 25% average risk weight (i.e. the IRB bank advantage is not as large as it is claimed to be).
The standardised risk weight does not seem to be the binding constraint so reducing it may not help the small banks much if the market looks through the change in regulatory risk measurement and concludes that nothing has changed in substance.

One way to change the portfolio quality status quo is for small banks to increase their share of low LVR loans with a 20% RW. Residential mortgages do not, for the most part, get originated at LVR of sub 50% but there is an opportunity for small banks to try to refinance seasoned loans where the dynamic LVR has declined. This brings us to the argument that IRB banks are taking the “cream” of the high quality low risk lending opportunities.

The “cream skimming” argument

A report commissioned by COBA argued that:

“While average risk weights for the major banks initially rose following the imposition of average risk weight on IRB banks by APRA, two of the major banks have since dramatically reduced their risk weights on residential mortgages with the lowest risk of default. The average risk weights on such loans is now currently on average less than 6 per cent across the major banks.”
“Despite the imposition of an average risk weight on residential home loans, it appears some of the major banks have decided to engage in cream skimming by targeting home loans with the lowest risk of default. Cream skimming occurs when the competitive pressure focuses on the high-demand customers (the cream) and not on low- demand ones (the skimmed milk) (Laffont & Tirole, 1990, p. 1042). Cream skimming has adverse consequences as it skews the level of risk in house lending away from the major banks and towards other ADIs who have to deal with an adversely selected and far riskier group of home loan applicants.”
“Reconciling Prudential Regulation with Competition” prepared by Pegasus Economics May 2019 (page 43)

It is entirely possible that I am missing something here but, from a pure capital requirement perspective, it is not clear that IRB banks have a material advantage in writing these low risk loans relative to the small bank competition. The overall IRB portfolio must still meet the 25% risk weight floor so any loans with 6% risk weights must be offset by risk weights (and hence riskier loans) that are materially higher than the 25% average requirement. I suspect that the focus on higher quality low risk borrowers by the IRB banks was more a response to the constraints on capacity to lend than something that was driven by the low risk weights themselves.

Under the proposed revised requirements, small banks in fact will probably have the advantage in writing sub 50% LVR loans given that they can do this at a 20% risk weight without the 25% floor on their average risk weights and without the additional capital requirements the IRB banks face.

I recognise there are not many loans originated at this LVR band but there is an opportunity in refinancing seasoned loans where the combined impact of principal reduction and increased property value reduces the LVR. In practice the capacity of small banks to do this profitably will be constrained by their relative expense and funding cost disadvantage. That looks to me to be a bigger issue impacting the ability of small banks to compete but that lies outside the domain of regulatory capital requirements.

Maybe this potential arbitrage does not matter in practice but APRA could quite reasonably impose a similar minimum average RW on Standardised Banks if the level playing field argument works both ways. This should be at least 25% but arguably higher once you factor in the fact that the small banks do not face the other capital requirements that IRB banks do. Even if APRA did not do this, I would expect the market to start looking more closely at the target CET1 for any small bank that accumulated a material share of these lower risk weight loans.

Implications

Nothing in this post is meant to suggest that increasing the risk sensitivity of the standardised risk weights is a bad idea. It seems doubtful however that this change alone will see small banks aggressively under cutting large bank competition. It is possible that small bank shareholders may benefit from improved returns on equity but even that depends on the extent to which the wholesale markets do not simply look through the change and require smaller banks to maintain the status quo capital commitment to residential mortgage lending.

What am I missing …

Every bank needs a cyclical capital buffer

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

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

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

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

Capital 101

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

Expected and unexpected credit loss

The BCBS publication from which this image is sourced explained that

“While it is never possible to know in advance the losses a bank will suffer in a particular year, a bank can forecast the average level of credit losses it can reasonably expect to experience. These losses are referred to as Expected Losses (EL) ….”
One of the functions of bank capital is to provide a buffer to protect a bank’s debt holders against peak losses that exceed expected levels… Losses above expected levels are usually referred to as Unexpected Losses (UL) – institutions know they will occur now and then, but they cannot know in advance their timing or severity….”
“An Explanatory Note on the Basel II IRB Risk Weight Functions” BCBS July 2005

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

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

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

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

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

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

Uncertainty is by definition not measurable

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

A better way of dealing with uncertainty

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

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

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

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

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

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

What gets you into trouble …

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so”
Commonly, possibly mistakenly, attributed to Mark Twain

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

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

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

Calibrating the size of the Cyclical Buffer

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

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

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

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

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

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

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

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

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

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

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

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

What about the prudential Counter-Cyclical Capital Buffer?

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

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

Summing up

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

What am I missing …

Tony