Tag: Capital Buffers

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

How much capital is enough? – The NZ perspective

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

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

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

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

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

Some preliminary thoughts …

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

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

Conclusion

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

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

Tony

Capital adequacy – an option to add transparency and flexibility into the “Unquestionably Strong” mix

Two of my earlier posts (here and here) discussed the potential to improve the capital adequacy framework by revisiting the calibration and operation of regulatory capital buffers. Some of the issues discussed in those posts are touched on in a discussion paper APRA has released titled “Improving the transparency, comparability and flexibility of the ADI capital framework“.

APRA is open to alternatives but sets out two options for discussion

In APRA’s words, the DP outlines

“… options to modify the ADI capital framework to improve transparency and comparability of reported capital ratios. The main conceptual approaches APRA is considering and seeking feedback on are:

  • developing more consistent disclosures without modifying the underlying capital framework; and

  • modifying the capital framework by adjusting the methodology for calculating capital ratios.”

The First Approach– “Consistent disclosure” – seems to be a beefed up version of the status quo in which APRA gets more directly involved in the comparability process by adding its imprimatur to the internationally harmonised ratios some Australian banks currently choose to disclose as an additional informal measure of capital strength.

“Under this approach, ADIs would continue to determine regulatory capital ratios using APRA’s definitions of capital and RWA. However, APRA would also specify a methodology for ADIs to determine certain adjustments to capital and RWA that could be used for disclosure (Pillar 3) purposes. As noted above, the methodology would focus on aspects of relative conservatism that are material in size and able to be calculated simply and objectively.”

APRA argues that “The supplementary disclosure would allow all stakeholders to better assess the capital strength of an ADI on a more comparable basis. However, it would result in two APRA-endorsed capital ratios: an APRA regulatory capital ratio to be compared against minimum requirements, and an additional disclosure-only capital ratio for, in particular, international comparison.”

A Second Approach – “Capital ratio adjustments” would involve APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and RWA.

The DP explains that this “… alternative approach would involve APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and RWA. This would involve removing certain aspects of relative conservatism from ADIs’ capital ratio calculations and lifting minimum regulatory capital ratio requirements in tandem. This increase in regulatory capital ratio requirements could be in the form of a transparent adjustment to minimum capital ratio requirements—for the purposes of this paper, such an adjustment is termed the ‘APRA Overlay Adjustment’.”

“To maintain overall capital adequacy, the APRA Overlay Adjustment would need to be calculated such that the total dollar amount of Prudential Capital Requirement (PCR) and Capital Conservation Buffer (CCB) would be the same as that required if these measures were not adopted. In other words, the risk-based capital requirements of ADIs would be unchanged in absolute dollar terms, maintaining financial safety, but adjustments to the numerator and the denominator of the capital ratio to be more internationally comparable would increase reported capital ratios.”

APRA clarify that

“These options are not mutually exclusive, and there is potential for both approaches to be adopted and applied in different areas.”

Approach 2 has some clear advantages …

It would make the “unquestionably strong” capital ratios more directly comparable with international peers, thereby reducing the potential for the perception of this strength to be obscured or misunderstood.

“Perception” is the key word here. It matters that the strength of Australian banks is simple, transparent and evident rather than being something where the perceivers must understand a sequence of relatively obscure and complex adjustments to fully appreciate the strength of a bank’s capital. More importantly perception matters most when the system is under stress and people do not have the time, or the inclination, to look beyond the reported numbers.

The adjusted capital ratio approach also provides opportunity to increase the flexibility of the ADI capital framework in times of stress but only to the extent to which the Overlay Adjustment is applied to the capital buffer, rather than increasing the minimum capital requirements. Higher minimum requirements would do nothing to enhance flexibility and may even be a backward step.

I believe a non zero baseline for the CCyB would also enhance the flexibility of the capital framework by virtue of the fact that it improves the odds that the banks (and APRA) have a flexible buffer in place before it is needed. This opportunity for enhanced flexibility is an option under both approaches so long as the Unquestionably Strong Benchmark maintains a material surplus over the Capital Conservation Buffer as it currently does.

But also some challenges …

APRA notes that the Adjusted Capital Ratio approach:

  • May significantly increase operational complexity for ADIs by virtue of the fact that the application of the APRA Overlay Adjustment would result in variable capital ratio requirements,

• Potentially results in variable minimum capital requirements which introduces complexity in analysing capital buffers and may undermine the desired transparency, and

• Reduces the dollar value of the 5.125 per cent (of RWA) loss absorption trigger point.

Do the advantages of the Adjusted Capital Ratio approach outweigh the challenges?

The short answer, I think, is yes … albeit with some qualifications.

So far as I can see, the added complexity only enters the discussion to the extent that some of the APRA Overlay Adjustment is applied to increase the minimum capital requirement. Most, if not all, of the operational complexity is avoided if the “Overlay Adjustment” is confined to increasing the size of the capital buffer.

Conversely, the benefits of increased responsiveness (or risk sensitivity) and flexibility lie in an increased capital buffer.

It follows then that the best way to pursue this approach is for any harmonised adjustments to the reported capital ratio to be confined to a higher CCB. This begs the question whether all the Overlay Adjustment should be applied to the capital buffer. I address that question in my responses below to some of the questions APRA has posed to solicit industry feedback.

One issue not covered in the Discussion Paper in any detail is that the capital ratios under Approach 2 will be more sensitive to any changes in the numerator. This is a simple mathematical consequence of RWA being lower if more harmonised measures are adopted. I do not see this as a problem but the heightened risk sensitivity of the framework needs to be clearly understood beforehand to minimise the potential for larger changes in capital ratios to be misunderstood. A more risk sensitive capital ratio may even be an advantage. This may not be obvious but there is a body of research which suggests a more responsive, more volatile, measure of capital adequacy can be beneficial to the extent that it prompts greater risk awareness on the part of bank management and external stakeholders. Greg Ip’s book “Foolproof” offers an introduction to some of this research but a simple example illustrating the point is the way that the benefits of improved braking in modern cars is offset to some extent by people driving faster.

APRA concludes its discussion paper with some direct questions.

There are 8 questions in all but in the context of this post I will have a go at addressing 3 of them, questions 2, 7 and 8.

Question 2: If APRA were to apply a combination of Approach 1 and Approach 2, which aspects of relative conservatism are best suited to be treated under Approach 2?

If you accept the argument that the minimum capital requirement should continue to be a set value (i.e. not subject to periodic adjustment), then the aspects of relative conservatism best suited to Approach 2 are those which can reasonably be assigned to an increase in, and regular adjustment of, one or more of the capital buffers.

Running through the list of adjustments currently applied to generate the internationally harmonised capital ratios, we can distinguish three broad categories of APRA conservatism:

  1. The extra credit risk related losses a bank might expect to experience under a very severe recession or financial crisis style scenario but not necessarily a gone concern where losses extend into the tail of the loss distribution
  2. Assets whose value depends on the ADI being a going concern and consequently are less certain to be realisable if the bank is in liquidation or has otherwise reached a point of non-viability
  3. Capital deduction intended to avoid “double counting” capital invested outside the ADI include

There are very few areas of black and white in the response to this question, but the first group are the items of APRA conservatism that I think have the clearest claim to be included in the capital buffer. These reflect potential loss scenarios that are conservative but still within the domain of plausibly severe downturns in the business cycle; this would encompass the following capital ratio adjustments:

  • the 20 per cent loss given default (LGD) portfolio constraint required for residential mortgage exposures;
  • the LGD parameter for unsecured non-retail exposures;
  • credit conversion factors (CCFs) for undrawn non-retail commitments;
  • use of supervisory slotting and the scaling factor for specialised lending;
  • risk weights for other retail exposures covered by the standardised approach to credit risk; and
  • the exchange rate used to convert Euro-denominated thresholds in the Basel capital framework into Australian dollars.

The second category are assets which have a value if the bank is a going concern but cannot necessarily be relied upon in non viability scenarios; I.e.

  • deferred tax assets arising from timing differences;
  • capitalised expenses and transaction costs
  • the capital requirement applied by APRA for IRRBB (I am open to arguments that I am being too harsh on IRRBB)

The third category captures capital that is committed to risks where the bank is taking a first loss exposure including

  • investments in other financial institutions;
  • holdings of subordinated tranches of securitisations.
  • investments in commercial entities;

Another way to explore this question is to map these three categories to the traditional graphic expression of a bank loss distribution and establish whether they are expected to lie:

  • closer to the middle of the loss distribution (sometimes framed as a 1 in 25 year downturn or the kinds of losses we expect in a severe downturn)
  • Or closer to the “tail” of the loss distribution (typically expressed as a 1 in 1000 year loss in regulatory capital terms).

To be clear, I am not seeking to ascribe any level of precision to these statistical probabilities; simply to distinguish between the relative likelihood of the items of conservatism that APRA has embedded in its current measure of capital adequacy. These three items tend to be treated as equivalent under the current approach and enhanced disclosure per Approach 1 will do nothing to address this conflation of risks.

Question 7: Would increasing the size of capital buffers (either by increasing the CCB or by setting a non-zero baseline CCyB) relative to PCR appropriately balance capital strength with financial stability through the cycle?

I have advocated the benefits of a non zero baseline CCYB in previous posts. One of these posts focused on the approach adopted by the Bank of England where I identified two advantages.

Firstly, it directly addresses the problem of failing to detect/predict when systemic risk in the banking system requires prudential intervention. A lot of progress has been made in dealing with this challenge, not the least of which has been to dispense with the idea that central banks had tamed the business cycle. The financial system however retains its capacity to surprise even its most expert and informed observers so I believe it is better to have the foundations of a usable counter cyclical capital buffer in place as soon as possible after the post crisis repair phase is concluded rather than trying to predict when it might be required.

The BOE approach still monitors a range of core indicators for the CCyB grouped into three categories.

• The first category includes measures of ‘non-bank balance sheet stretch’, capturing leverage in the broader economy and in the private non-financial (ie household and corporate) sector specifically.

• The second category includes measures of ‘conditions and terms in markets’, which capture borrowing terms on new lending and investor risk appetite more broadly.

• The third category includes measures of ‘bank balance sheet stretch’, which capture leverage and maturity/liquidity transformation in the banking system.

However the BOE implicitly accepts that it can’t predict the future so it substitutes a simple, pragmatic and error resilient strategy (put the default CCyB buffer in place ASAP) for the harder problem of trying to predict when it will be needed. This strategy retains the option of increasing the CCyB, is simpler to administer and less prone to error than the standard BCBS approach. The BOE might still miss the turning point but it has a head start on the problem if it does.

The BOE also integrates its CCyB strategy with its approach to stress testing. Each year the stress tests include a scenario:

“intended to assess the risks to the banking system emanating from the financial cycle – the “annual cyclical scenario”

The severity of this scenario will increase as risks build and decrease after those risks crystallise or abate. The scenario might therefore be most severe during a period of exuberance — for example, when credit and asset prices are growing rapidly and risk premia are compressed. That might well be the point when markets and financial institutions consider risks to be lowest. And severity will be lower when exuberance has corrected — often the time at which markets assess risks to be largest. In leaning against these tendencies, the stress-testing framework will lean against the cyclicality of risk taking: it will be countercyclical.”

The Bank of England’s approach to stress testing the UK banking system – October 2015 (page 5)

I have discussed the BOE approach at length but the Canadian supervisor has also introduced some interesting innovations in the way that it uses a capital buffer to address the systemic risk of large banks that are worth considering as part of this review.

The second reason I favour a non zero baseline is because I believe it is likely to result in a more “usable” buffer once risk crystallizes (not just systemic risk) and losses start to escalate.

In theory, the standard capital conservation buffer (CCB) introduced under Basel III can absorb any unexpected increase in losses and allow banks the time to progressively rebuild the buffer when economic conditions improve

In practice, the upper boundary of the CCB acts as a de facto minimum requirement such that banks face strong market pressure to immediately rebuild the buffer potentially at material cost to shareholders

There are no guarantees for what happens to banking systems under stress, but a flexible buffer that is sensitive to the state of the credit cycle is I think far more fit for purpose.

It is important to note that a non zero CCYB is an option under both approaches. There is potentially enough surplus capital in the Unquestionably Strong calibration for a non-zero CCYB to be introduced without requiring banks to raise any more capital. This would be so under either of the approaches that APRA has outlined.

So a larger buffer would be desirable from the perspective of increased comparability and transparency but the advantages of a non zero CCYB could also be pursued under the Unquestionably Strong status quo or Approach 1.

Question 8: What may be some of the potential impacts if APRA increases the prescribed loss absorption trigger point above 5.125 per cent of RWA?

The rationale for increasing the PONV Trigger is that APRA believes it is important to preserve the value of the trigger in dollar terms.

I can see that it is important to have a PONV trigger well before a bank reaches the point of insolvency (I.e. where liabilities exceed assets).

It is less clear that the reduction in the dollar value of the trigger point is sufficiently material to matter.

What really matters is the amount of contingent capital available to be converted into common equity if the PONV conversion trigger is pulled.

In the absence of this source of new capital, the fact that a bank has X billion dollars more or less of book equity (according to the financial accounts) at the point of deemed non-viability is arguably irrelevant to whether it remains a going concern.

I am also pretty sure that we do not want the operational complexity associated with a PONV trigger that moves around over time as a result of seeking to compensate for the impact of the Overlay Adjustment on capital deductions and RWA.