Banks Are Managing Their Stress – Bloomberg

The ever reliable Matt Levine discusses the latest stress test results for the US banks. In particular the disconnect between the severity of the assumptions in the hypothetical scenario and the actual results observed to date. He notes that it is still early and plenty of room for the actual outcomes to catch up with the hypothetical. However, one of the issues with stress testing is the way you model the way people (and governments) respond to stress.

As Matt puts it …

But another important answer is that, when a crisis actually happens, people do something about it. They react, and try to make it better. In the case of the coronavirus crisis, the Fed and the U.S. government tried to mitigate the effect of a real disaster on economic and financial conditions. Unemployment is really high, but some of the consequences are mitigated by stimulus payments and increased unemployment benefits. Asset prices fell sharply, but then rose sharply as the Fed backstopped markets. Financing markets seized up, and then the Fed fixed them.

The banks themselves also acted to make things better, at least for themselves. One thing that often happens in a financial crisis is that banks’ trading desks make a killing trading for clients in turbulent markets, which helps to make up for some of the money they lose on bad loans. And in fact many banks had blowout first quarters in their trading divisions: Clients wanted to trade and would pay a lot for liquidity, and banks took their money.

In a hypothetical stress test, you can’t really account for any of this. If you’re a bank, and the Fed asks you to model how you’d handle a huge financial crisis, you can’t really write down “I would simply make a ton of money trading derivatives.” It is too cute, too optimistic. But in reality, lots of banks just went and did that.

Similarly, you obviously can’t write down “I would simply rely on the Fed to backstop asset prices and liquidity.” That is super cheating. Much of the purpose of the stress tests is to make it so the Fed doesn’t have to bail out the banking system; the point is to demonstrate that the banks can survive a financial crisis on their own without government support. But in reality, having a functioning financial system is better than not having that, so the Fed did intervene; keeping people in their homes is better than foreclosing on them, so the government supported incomes. So the banks are doing much better than you might expect with 13.3% unemployment.

So it is likely that the Fed’s stress test is both not harsh enough, in its economic scenario, and too harsh, in its assumption about how that scenario will affect banks.

Notwithstanding the potential for people to respond to and mitigate stress, there is still plenty of room for reality to catch up with and exceed the hypothetical scenario. Back to Matt…

But the fact that the stress test imagines an economic crisis that is much nicer than reality is still a little embarrassing, and the Fed can’t really say “everything is fine even in the terrible downside case of 10% unemployment, the banks are doing great.” So it also produced some new stress-test results (well, not quite a full stress test but a “sensitivity analysis”) assuming various scenarios about the recovery from the Covid crisis (“a rapid V-shaped recovery,” “a slower, more U-shaped recovery,” and “a W-shaped double dip recession”). The banks are much less well capitalized in those scenarios than they are either (1) now or (2) in the original stress tests, though mostly still okay, and the Fed is asking the banks to reconsider stress and capital based on current reality. Also stop share buybacks:

Worth reading

Tony – From the Outside

Capital adequacy reform – new learnings from the crisis

A speech by APRA Chair Wayne Byres released today had some useful remarks on the post 2008 capital adequacy reforms and what we have learned thus far. A few observations stood out for me. Firstly, a statement of the obvious is that the reforms are getting their first real test and we are likely to find areas for improvement

“… the post-2008 reforms will be properly tested, and inevitably we will find areas they can be improved.”

The speech clarifies that just how much, if any, change is required is not clear at this stage

“Before anyone misinterprets that comment, I am not advocating a watering down of the post-2008 reforms. It may in fact turn out they’re insufficient, and we need to do more. Maybe they just need to be reshaped a bit. I do not know. But inevitably there will be things we learn, and we should not allow a determination not to backtrack on reforms to deter us from improving them.”

Everyone is focused on fighting the COVID 19 fire at the moment but a discussion paper released in 2018 offered some insights into the kinds of reforms that APRA was contemplating before the crisis took priority. It will be interesting to see how the ideas floated in this discussion paper are refined or revised in the light of what we and APRA learn from this crisis. One of the options discussed in that 2018 paper involved “APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and RWA“. It was interesting therefore to note that the speech released today referred to the internationally comparable ratios rather than APRA’s local interpretation of Basel III.

“We had been working for some years to position our largest banks in the top quartile of international peers from a capital adequacy perspective, and fortuitously they had achieved that positioning before the crisis struck. On an internationally comparable basis, our largest banks are operating with CET1 ratios in the order of 15-16 per cent, and capital within the broader banking system is at a historical high – and about twice the level heading into the 2008 crisis.”

The speech makes a particular note of what we are learning about the capacity to use capital buffers.

“One area where I think we are learning a lot at present is the ability to use buffers. It is not as easy as hoped, despite them having been explicitly created for use during a crisis. One blockage does seem to be that markets, investors and rating agencies have all adjusted to contemporary capital adequacy ratios as (as the name implies) ‘adequate capital’. But in many jurisdictions, like Australia, ratios are at historical highs. We often hear concern about our major banks’ CET1 ratios falling below 10 per cent. This is even though, until a few years ago, their CET1 ratios had never been above 10 per cent and yet they were regarded as strong banks with AA ratings. So expectations seem to have shifted and created a new de facto minimum. We need to think about how to reset that expectation.”

I definitely agree that there is more to do on the use of capital buffers and have set out my own thoughts on the topic here. One thing not mentioned in the speech is the impact of procyclicality on the use of capital ratios.

This chart from a recent Macquarie Wealth Management report summarises the disclosure made by the big four Australian banks on the estimated impact of the deterioration in credit quality that banks inevitably experience under adverse economic conditions such as are playing out now. The estimated impacts collated here are a function of average risk weights calculated under the IRB approach increasing as average credit deteriorates. This is obviously related to the impact of increased loan loss provisioning on the capital adequacy numerator but a separate factor driving the capital ratios down via its impact on the denominator of the capital ratio.

There are almost certainly issues with the consistency and comparability of the disclosure but it does give a rough sense of the materiality of this factor which I think is not especially well understood. This is relevant to some some observations in Wayne Byres speech about the capital rebuilding process.

A second possible blockage is possibly that regulatory statements permitting banks to use their buffers are only providing half the story. Quite reasonably, what banks (and their investors) need to understand before they contemplate using buffers is the expectation as to their restoration. But we bank supervisors do not have a crystal ball – we cannot confidently predict the economic pathway, so we cannot provide a firm timetable. The best I can offer is that it should be as soon a circumstances reasonably allow, but no sooner. In Australia, I would point to the example of the way we allowed Australian banks to build up capital to meet their ‘unquestionably strong’ benchmarks in an orderly way over a number of years. We should not be complacent about the rebuild, but there are also risks from rushing it.”

Given that the estimated impacts summarised in the chart above are entirely due to “RWA inflation” as credit quality deteriorates, it seems reasonable to assume that part of the capital buffer rebuild will be generated by the expected decline in average risk weights as credit quality improves. The capital buffers will in a sense partly self repair independent of what is happening to the capital adequacy numerator.

I think we had an academic understanding of the capital ratio impact of this RWA inflation and deflation process pre COVID 19 but will have learned a lot more once the dust settles.

Tony – From the Outside

Bank dividends

Matt Levine’s “Money Stuff” column (Bloomberg) offers some interesting commentary on what is happening with bank dividends in the US. Under the sub heading “People are worried about dividends” he writes:

So, again, I am generally pretty impressed by the performance of bank regulation in the current crisis, but this is unfortunate:

US banks’ annual capital plans, due to be submitted to the Federal Reserve on Monday, are expected to include proposals to continue paying dividends, reinforcing comments from prominent bank chief executives in recent days, according to people familiar with the situation.

The bankers, including Goldman Sachs boss David Solomon, Morgan Stanley boss James Gorman and Citigroup chief Mike Corbat, argued that they had the means to continue paying dividends and that cutting them would be “destabilising to investors”.

“We’re in a very different position than what we see in Europe,” said Marty Mosby, a veteran banks analyst at Vining Sparks.

“How we set it up [post-crisis capital requirements] was to be able to not have those dividends collapse [in a crisis]. That’s what creates a financial crisis: when dividends start to be ratcheted lower that shakes confidence.”

What is unfortunate is not so much that U.S. banks want to continue paying dividends; for all I know some of them are so well capitalized and so well equipped to weather this crisis that they will actually make a lot of money and have plentiful profits to pay out to shareholders. What is unfortunate is that their explicit view is that cutting dividends would be destabilizing. Common shareholders are supposed to be the lowest-ranking claimants on a bank’s money. The point of equity capital is that you don’t have to pay it out, that it doesn’t create any cash drain in difficult times. But if your view is “we need to maintain our dividend every quarter or else there will be a run on the bank,” then that means that the dividend is destabilizing; it means that your common stock is really debt; it means that your equity capital is not as good—not as equity-like—as it’s supposed to be.

If you take seriously the claim that banks can’t cut dividends in a generational crisis, for fear of undermining investor confidence, then, fine, I guess, but then the obvious conclusion is that when times are good you can never let banks raise their dividends. Every time a bank raises its dividend, on this theory, it incurs more unavoidable quarterly debt and creates a new drain on its funding, one that can’t be turned off in the bad times for fear of being “destabilising to investors”

Bloomberg Opinion “Money Stuff” 7 April 2020

I get the argument that if banks have the means to pay a dividend then they should be free to make a commercial decision. People may however feel entitled to be skeptical given the ways in which some banks were slow to adjust to the new realities of the GFC. There is also a line where the position some US banks appear to be projecting risks becoming an expectation that the dividend should be stable even under a highly stressed and uncertain outlook. It is not clear if that is exactly what the US banks quoted in his column are saying but that is how Matt Levine frames it and it would clearly be a concern if that is their view. That does seem to a fair description of the view some investors and analysts are expressing.

Jamie Dimon seems to be offering a more nuanced perspective on this question. He has advised JP Morgan shareholders that the Board expects the bank to remain profitable under its base base projections but would consider suspending the dividend under an extremely adverse scenario.

Our 2019 pretax earnings were $48 billion – a huge and powerful earnings stream that enables us to absorb the loss of revenues and the higher credit costs that inevitably follow a crisis. For comparison, the Comprehensive Capital Analysis and Review (CCAR) results for 2020 that we submitted to the Federal Reserve in 2019 (which assumed outcomes like U.S. unemployment peaking at 10% and the stock market falling 50%) showed a decline in revenue of almost 20% and credit costs of approximately $20 billion more than what we experienced in 2019. We believe we would perform better than this if the Fed’s scenario were to actually occur. But even in the Fed’s scenario, we would be profitable in every quarter. These stress test results also show that following such a meaningful reduction in our revenue (and assuming we continue to pay dividends), our common equity Tier 1 (CET1) ratio would likely hold at a very strong 10%, and we would have in excess of $500 billion of liquid assets. 

Additionally, we have run an extremely adverse scenario that assumes an even deeper contraction of gross domestic product, down as much as 35% in the second quarter and lasting through the end of the year, and with U.S. unemployment continuing to increase, peaking at 14% in the fourth quarter. Even under this scenario, the company would still end the year with strong liquidity and a CET1 ratio of approximately 9.5% (common equity Tier 1 capital would still total $170 billion). This scenario is quite severe and, we hope, unlikely. If it were to play out, the Board would likely consider suspending the dividend even though it is a rather small claim on our equity capital base. If the Board suspended the dividend, it would be out of extreme prudence and based upon continued uncertainty over what the next few years will bring.

It is also important to be aware that in both our central case scenario for 2020 results and in our extremely adverse scenario, we are lending – currently or plan to do so – an additional $150 billion for our clients’ needs. Despite this, our capital resources and liquidity are very strong in both models. We have over $500 billion in total liquid assets and an incremental $300+ billion borrowing capacity at the Federal Reserve and Federal Home Loan Banks, if needed, to support these loans, as well as meet our liquidity requirements (these numbers do not include the potential use of some of the Fed’s newly created facilities). We could, of course, make our capital and liquidity buffer better by restricting our activities, but we do not intend to do that – our clients need us.

JP Morgan Chairman and CEO Letter to Shareholders 2019 Annual Report

Banks are cyclical investments – who knew?

Stress testing models must of course be treated with caution but what I think this mostly illustrates is that banks are highly cyclical investments. That may seem like a statement of the obvious but there was a narrative post GFC that banks were public utilities and that bank shareholders should expect to earn public utility style returns on their investments.

There is an element of truth in this analogy in so far as banks clearly provide an essential public service. I am also sympathetic to the argument that banking is a form of private/public partnership. This pandemic is however a timely reminder of the limits of the argument that banks are just another low risk utility style of business. Bank shareholders are much more exposed to the cyclical impacts than true utility investments.

In the interests of full disclosure, I have a substantial exposure to bank shares and I for one need a lot more than a single digit return to compensate for the pain that part of my portfolio is currently experiencing. The only upside is that I never bought into the thesis that banks are a low risk utility style investment requiring a commensurately low return.

The higher capital and liquidity requirements built up in response to the lessons of the GFC increase the odds that banks will survive the crisis and be a big part of the solution but banks are, and remain, quintessentially cyclical investments and the return bank investors require should reflect this. I think the lesson here is not to worry about the extent to which dividend cuts would be destabilising to investors but to focus on what kind of return is commensurate with the risk.

I will let APRA have the final say on what to expect …

APRA expects ADIs and insurers to limit discretionary capital distributions in the months ahead, to ensure that they instead use buffers and maintain capacity to continue to lend and underwrite insurance. This includes prudent reductions in dividends, taking into account the uncertain outlook for the operating environment and the need to preserve capacity to prioritise these critical activities. 

Decisions on capital management need to be forward-looking, and in the current environment of significant uncertainty in the outlook, this can be very challenging. APRA is therefore providing Boards with the following additional guidance.2 

During at least the next couple of months, APRA expects that all ADIs and insurers will:

– take a forward-looking view on the need to conserve capital and use capacity to support the economy;

– use stress testing to inform these views, and give due consideration to plausible downside scenarios (periodically refreshed and updated as conditions evolve); and

– initiate prudent capital management actions in response, on a pre-emptive basis, to ensure they maintain the confidence and capacity to continue to lend and support their customers. 

During this period, APRA expects that ADIs and insurers will seriously consider deferring decisions on the appropriate level of dividends until the outlook is clearer. However, where a Board is confident that they are able to approve a dividend before this, on the basis of robust stress testing results that have been discussed with APRA, this should nevertheless be at a materially reduced level. Dividend payments should be offset to the extent possible through the use of dividend reinvestment plans and other capital management initiatives. APRA also expects that Boards will appropriately limit executive cash bonuses, mindful of the current challenging environment.  

“APRA issues guidance to authorised deposit-taking institutions and insurers on capital management”, 7 April 2020

Tony (From the Outside)

ECB acknowledges the potential for IFRS 9 to amplify procyclicality

This ECB press release lists four initiatives to deal with impact of Covid 19

  • ECB gives banks further flexibility in prudential treatment of loans backed by public support measures 
  • ECB encourages banks to avoid excessive procyclical effects when applying the IFRS 9 international accounting standard 
  • ECB activates capital and operational relief measures announced on March 12, 2020
  • Capital relief amounts to €120 billion and could be used to absorb losses or potentially finance up to €1.8 trillion of lending

This guidance on flexibility is helpful (arguably necessary) but it would have been better if the relationship between loan loss provisioning and capital buffers was more clearly thought through and built into the design of the system before it was subject to its first real test.

Tony

IFRS 9 loan loss provisioning faces its first real test

My long held view has been that IFSR 9 adds to the procyclicality of the banking system (see here, here, and here) and that the answer to this aspect of procyclicality lies in the way that capital buffers interact with loan loss provisioning (here, here, and here).

So it was interesting to see an article in the Financial Times overnight headlined “New accounting rules pose threat to banks amid virus outbreak”. The headline may be a bit dramatic but it does draw attention to the IFRS 9 problem I have been concerned with for some time.

The article notes signs of a backlash against the accounting rules with the Association of German Banks lobbying for a “more flexible handling” of risk provisions under IFRS 9 and warning that the accounting requirements could “massively amplify” the impact of the crisis. I agree that the potential exists to amplify the crisis but also side with an unnamed “European banking executive” quoted in the article saying “IFRS 9, I hate it as a rule, but relaxing accounting standards in a crisis just doesn’t look right”.

There may be some scope for flexibility in the application of the accounting standards (not my area of expertise) but that looks to me like a dangerous and slippery path to tread. The better option is for flexibility in the capital requirements, capital buffers in particular. What we are experiencing is exactly the kind of adverse scenario that capital buffers are intended to absorb and so we should expect them to decline as loan loss provisions increase and revenue declines. More importantly we should be seeing this as a sign that the extra capital put in place post the GFC is performing its assigned task and not a sign, in and of itself, indicating distress.

This experience will also hopefully reinforce the case for ensuring that the default position is that the Counter Cyclical Capital Buffer be in place well before there are any signs that it might be required. APRA announced that it was looking at this policy in an announcement in December 2019 but sadly has not had the opportunity to fully explore the policy initiative and implement it.

Tony

Capital Rules Get Less Stressful – Matt Levine

Nice quote from Matt Levine’s opinion piece on the change in US bank capital requirements

Everything in bank capital is controversial so this is controversial. Usually the controversy is that some people want higher capital requirements and other people want lower capital requirements. Here, pleasantly, part of the controversy is about whether this is a higher or lower capital requirement.

https://www.bloomberg.com/opinion/articles/2020-03-05/capital-rules-get-less-stressful

Possible pitfalls of a 1-in-X approach to financial stability – Bank Underground

Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed are those of the authors, and are not necessarily those of the Bank of England, or its policy committees. Posting on this blog, Adam Brinley Codd and Andrew Gimber argue that false confidence in people’s ability to calculate probabilities of rare events might end up worsening the crises regulators are trying to prevent.

The post concludes with their personal observations about how best to deal with this meta-uncertainty.

Policymakers could avoid talking about probabilities altogether. Instead of a 1-in-X event, the Bank of England’s Annual Cyclical Scenario is described as a “coherent ‘tail risk’ scenario”.

Policymakers could avoid some of the cognitive biases that afflict people’s thinking about low-probability events, by rephrasing low-probability events in terms of less extreme numbers. A “100-year” flood has a 1% chance of happening in any given year, but anyone who lives into their 70s is more likely than not to see one in their lifetime.

Policymakers could  be vocal about the fact that there are worse outcomes beyond the 1-in-X point of the distribution.

— Read on bankunderground.co.uk/2020/02/06/possible-pitfalls-of-a-1-in-x-approach-to-financial-stability/

APRA announces that it will consider a non-zero default level for the counter cyclical capital buffer

The Australian Prudential Regulation Authority (APRA) announced today that it had decided to keep the countercyclical capital buffer (CCyB) for authorised deposit-taking institutions (ADIs) on hold at zero per cent. What was really interesting however is that the information paper also flagged the likelihood of a non-zero default level in the future.

Here is the relevant extract from the APRA media release:

…. the information paper notes that APRA is also giving consideration to introducing a non-zero default level for the CCyB as part of its broader reforms to the ADI capital framework.

APRA Chair Wayne Byres said: “Given current conditions, and the financial strength built up within the banking sector, a zero counter-cyclical buffer remains appropriate.

“However, setting the countercyclical capital buffer’s default position at a non-zero level as part of the ‘unquestionably strong’ framework would not only preserve the resilience of the banking sector, but also provide more flexibility to adjust the buffer in response to material changes in financial stability risks. This is something APRA will consult on as part of the next stage of the capital reforms currently underway.

“Importantly, this would be considered within the capital targets previously announced – it does not reflect any intention to further raise minimum capital requirements.”

“APRA flags setting the countercyclical capital buffer at non-zero level”, APRA media announcement, 11 December 2019

I have argued the case for a non-zero default setting on this buffer in a long form note I published on my blog here, and published some shorter posts on the countercyclical capital buffer here, here and here). One important caveat is is that incorporating a non-zero default for the CCyB does not necessarily means that a bank needs to hold more capital. It is likely to be sufficient to simply partition a set amount of the existing capital surplus. In this regard, it is interesting that APRA has explicitly linked this potential change to the review it it initiated in the August 2018 Discussion Paper on “Improving the transparency, comparability and flexibility of the ADI capital framework”.

I covered that discussion paper in some depth here but one of the options discussed in this paper (“Capital ratio adjustments”) involves APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and Risk Weighted Assets.

Summing up, I would rate this as a positive development but we need to watch how the policy development process plays out.

Tony

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

Every bank needs a cyclical capital buffer

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

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

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

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

Capital 101

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

Expected and unexpected credit loss

Figure 1 – Expected and Unexpected Loss

The BCBS publication from which this image is sourced explained that

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

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

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

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

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

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

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

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

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

Uncertainty is by definition not measurable

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

A better way of dealing with uncertainty

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

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

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

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

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

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

What gets you into trouble …

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

Commonly, possibly mistakenly, attributed to Mark Twain

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

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

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

Calibrating the size of the Cyclical Buffer

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

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

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

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

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

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

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

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

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

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

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

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

What about the prudential Counter-Cyclical Capital Buffer?

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

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

Summing up

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

What am I missing …

Tony