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.
In Capital 101, we learn that capital is meant to cover “unexpected loss” and that there is a neat division between expected and unexpected loss. The extract below from an early BCBS publication sets out the standard explanation …
Expected and unexpected credit loss
The BCBS publication from which this image is sourced explained that
“While it is never possible to know in advance the losses a bank will suffer in a particular year, a bank can forecast the average level of credit losses it can reasonably expect to experience. These losses are referred to as Expected Losses (EL) ….”
One of the functions of bank capital is to provide a buffer to protect a bank’s debt holders against peak losses that exceed expected levels… Losses above expected levels are usually referred to as Unexpected Losses (UL) – institutions know they will occur now and then, but they cannot know in advance their timing or severity….”
“An Explanatory Note on the Basel II IRB Risk Weight Functions” BCBS July 2005
There was a time when the Internal Ratings Based approach, combining some elegant theory and relatively simple math, seemed to have all the answers
A simple intuitive division between expected and unexpected loss
Allowing expected loss to be quantified and directly covered by risk margins in pricing while the required return on unexpected loss could be assigned to the cost of equity
A precise relationship between expected and unexpected loss, defined by the statistical parameters of the assumed loss distribution
The capacity to “control” the risk of unexpected loss by applying seemingly unquestionably strong confidence levels (i.e. typically 1:1000 years plus) to the measurement of target capital requirements
It even seemed to offer a means of neatly calibrating the capital requirement to the probability of default of your target debt rating (e.g. a AA senior debt rating with a 5bp probability of default = a 99.95% confidence level; QED)
If only it was that simple … but expected loss is still a good place to start
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.
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
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”.
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.
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
I may not always agree with everything they have to say, but there are a few people who reliably produce content and ideas worth reading, Andy Haldane is one and Claudio Borio is another (see previous posts on Haldane here and Borio here for examples of their work). So I was interested to read what Borio had to say about the introduction of Expected Credit Loss (ECL) provisioning. ECL is one of those topic that only interests the die-hard bank capital and credit tragics but I believe it has the potential to create some problems in the real world some way down the track.
Borio’s position is that:
Relative to the “incurred loss” approach to credit risk that precedes it, the new standard is likely to mitigate pro cyclicality to some extent;
But it will not be sufficient on its own to eliminate the risk of adverse pro cyclical impacts on the real economy;
So there is a need to develop what he calls “capital filters” (a generic term encompassing capital buffers and other tools that help mitigate the risk of pro cyclicality) that will work in conjunction with, and complement, the operation of the loan loss provisions in managing credit risk.
There are two ways to respond to Claudio Borio’s observations on this topic:
One is to take issue with his view that Expected Credit Loss provisioning will do anything at all to mitigate pro cyclicality;
The second is to focus on his conclusion that ECL provisioning by itself is not enough and that a truly resilient financial system requires an approach that complements loan provisions
Will ECL reduce the risk of pro cyclicality?
It is true that, relative to the incurred loss model, the ECL approach will allow loan loss provisions to be put in place sooner (all other things being equal). In scenarios where banks have a good handle on deteriorating economic conditions, then it does gives more freedom to increase provisions without the constraint of this being seen to be a cynical device to “smooth” profits.
The problem I see in this assessment is that the real problems with the adequacy of loan provisioning occur when banks (and markets) are surprised by the speed, severity and duration of an economic downturn. In these scenarios, the banks may well have more ECL provisions than they would otherwise have had, but they will probably still be under provisioned.
This will be accentuated to the extent that the severity of the downturn is compounded by any systematic weakness in the quality of loans originated by the banks (or other risk management failures) because bank management will probably be blind to these failures and hence slow to respond. I don’t think any form of Expected Loss can deal with this because we have moved from expected loss to the domain of uncertainty.
The solution to pro cyclicality lies in capital not expected loss
So the real issue is what to do about that. Borio argues that, ECL helps, but you really need to address the problem via what he refers to as “capital filters” (what we might label as counter cyclical capital buffers though that term is tainted by the failure of the existing system to do much of practical value thus far). On this part of his assessment, I find myself in violent agreement with him:
let accounting standards do what they do, don’t try to make them solve prudential problems;
construct a capital adequacy solution that complements the accounting based measurement of capital and profits.
Borio does not offer any detail on exactly what these capital solutions might look like, but the Bank of England and the OFSI are working on two options that I think are definitely worth considering.
In the interim, the main takeaway for me is that ECL alone is not enough on its own to address the problem of pro cyclicality and, more importantly, it is dangerous to think it can.
I had been intending to write a post on the potential time bomb for bank capital embedded in IFSR9 but Adrian Docherty has saved me the trouble. He recently released an update on IFRS9 and CECL titled Much Ado About Nothing or Après Moi. Le Deluge?
This post is fairly technical so feel free to stop here if you are not a bank capital nerd. However, if you happen to read someone saying that IFRS 9 solves one of the big problems encountered by banks during the GFC then be very sceptical. Adrian (and I) believe that is very far from the truth. For those not discouraged by the technical warning, please read on.
The short version of Adrian’s note is:
The one-off transition impact of the new standard is immaterial and the market has largely ignored it
Market apathy will persist until stressed provisions are observed
The dangers of ECL provisioning (procyclical volatility, complexity and subjectivity) have been confirmed by the authorities …
… but criticism of IFRS 9 is politically incorrect since the “correct” narrative is that earlier loan loss provisioning fulfils the G20 mandate to address the problem encountered during the GFC
Regulatory adaption has been limited to transition rules, which are not a solution. We need a fundamentally revised Basel regime – “Basel V” – in which lifetime ECL provisions somehow offset regulatory capital requirements.
Adrian quotes at length from Bank of England (BoE) commentary on IFRS 9. He notes that their policy intention is that the loss absorbing capacity of the banking system is not impacted by the change in accounting standards but he takes issue with the way that they have chosen to implement this policy approach. He also calls out the problem with the BoE instruction that banks should assume “perfect foresight” in their stress test calculations.
Adrian also offers a very useful deconstruction of what the European Systemic Risk Board had to say in a report they published in July 2017 . He has created a table in which he sets out what the report says on one column and what they mean in another (see page 8 of Adrian’s note).
This extract from Adrian’s note calls into question whether the solution developed is actually what the G20 asked for …
“In official documents, the authorities still cling to the assertion that ECL provisioning is good for financial stability “if soundly implemented” or “if properly applied”. They claim that the new standard “means that provisions for potential credit losses will be made in a timely way”. But what they want is contrarian, anti-cyclical ECL provisioning. This is simply not possible, in part because of human psychology but, more importantly, because the standard requires justifiable projections based on objective, consensual evidence.
Surely the authorities know they are wrong? Their arguments don’t stack up.
They hide behind repeated statements that the G20 instructed them to deliver ECL provisioning, whereas a re-read of the actual instructions clearly shows that a procyclical, subjective and complex regime was not what was asked for.
It just doesn’t add up.”
There is of course no going back at this point, so Adrian (rightly I think) argues that the solution lies in a change to banking regulation to make Basel compatible with ECL provisioning. I will quote Adrian at length here
“So the real target is to change banking regulation, to make Basel compatible with ECL provisioning. Doing this properly would constitute a genuine “Basel V”. Yes, the markets would still need to grapple with complex and misleading IFRS 9 numbers to assess performance. But if the solvency calculation could somehow adjust properly for ECL provisions, then solvency would be stronger and less volatile.
And, in an existential way, solvency is what really matters – it’s the sina qua nonof a bank. Regulatory solvency drives the ability of a bank to grow the business and distribute capital. Accounting profit matters less than the generation of genuinely surplus solvency capital resources.
Basel V should remove or resolve the double count between lifetime ECL provisions and one-year unexpected loss (UL) capital resources. There are many different ways of doing this, for example:
A. Treat “excess provisions” (the difference between one-year ECL and lifetime ECL for Stage 2 loans) as CET1
B. Incorporate expected future margin as a positive asset, offsetting the impact of expected future credit losses
C. Reduce capital requirements by the amount of “excess provisions” (again, the difference between one-year ECL and lifetime ECL for Stage 2 loans) maybe with a floor at zero
D. Reduce minimum regulatory solvency ratios for banks with ECL provisioning (say, replacing the Basel 8% minimum capital ratio requirement to 4%)
All of these seem unpalatable at first sight! To get the right answer, there is a need to conduct a fundamental rethink. Sadly, there is no evidence that this process has started. The last time that there was good thinking on the nature of capital from Basel was some 17 years ago. It’s worth re-reading old papers to remind oneself of the interaction between expected loss, unexpected loss and income. The Basel capital construct needs to be rebuilt to take into account the drastically different meaning of the new, post-IFRS 9 accounting equity number.”
Hopefully this post will encourage you to read Adrian’s note and to recognise that IFRS 9 is not the cycle mitigating saviour of banking it is represented to be. The core problem is not so much with IFRS9 itself (though its complexity and subjectivity are issues) but more that bank capital requirements are not constructed in a way that compensates for the inherent cyclicality of the banking industry. The ideas that Adrian has listed above are potentially part of the solution as is revisiting the way that the Counter cyclical Capital Buffer is intended to operate.
Claudio Borio at the BIS wrote an interesting paper exploring the “financial cycle”. This post seeks to summarise the key points of the paper and draw out some implications for bank stress testing (the original paper can be found here). The paper was published in December 2012, so its discussion of the implications for macroeconomic modelling may be dated but I believe it continues to have some useful insights for the challenges banks face in dealing with adverse economic conditions and the boundary between risk and uncertainty.
Key observations Borio makes regarding the Financial Cycle
The concept of a “business cycle”, in the sense of there being a regular occurrence of peaks and troughs in business activity, is widely known but the concept of a “financial cycle” is a distinct variation on this theme that is possibly less well understood. Borio states that there is no consensus definition but he uses the term to
“denote self-reinforcing interactions between perceptions of value and risk, attitudes towards risk and financing constraints, which translate into booms followed by busts. These interactions can amplify economic fluctuations and possibly lead to serious financial distress and economic disruption”.
This definition is closely related to the concept of “procyclicality” in the financial system and should not be confused with a generic description of cycles in economic activity and asset prices. Borio does not use these words but I have seen the term “balance sheet recession” employed to describe much the same phenomenon as Borio’s financial cycle.
Borio identifies five features that describe the Financial Cycle
It is best captured by the joint behaviour of credit and property prices – these variables tend to closely co-vary, especially at low frequencies, reflecting the importance of credit in the financing of construction and the purchase of property.
It is much longer, and has a much larger amplitude, than the traditional business cycle – the business cycle involves frequencies from 1 to 8 years whereas the average length of the financial cycle is longer; Borio cites a cycle length of 16 years in a study of seven industrialised economies and I have seen other studies indicating a longer cycle (with more severe impacts).
It is closely associated with systemic banking crises which tend to occur close to its peak.
It permits the identification of the risks of future financial crises in real time and with a good lead – Borio states that the most promising leading indicators of financial crises are based on simultaneous positive deviations of the ratio of private sector credit-to-GDP and asset prices, especially property prices, from historical norms.
And it is highly dependent of the financial, monetary and real-economy policy regimes in place (e.g. financial liberalisation under Basel II, monetary policy focussed primarily on inflation targeting and globalisation in the real economy).
Macro economic modelling
Borio also argues that the conventional models used to analyse the economy are deficient because they do not capture the dynamics of the financial cycle. These extracts capture the main points of his critique:
“The notion… of financial booms followed by busts, actually predates the much more common and influential one of the business cycle …. But for most of the postwar period it fell out of favour. It featured, more or less prominently, only in the accounts of economists outside the mainstream (eg, Minsky (1982) and Kindleberger (2000)). Indeed, financial factors in general progressively disappeared from macroeconomists’ radar screen. Finance came to be seen effectively as a veil – a factor that, as a first approximation, could be ignored when seeking to understand business fluctuations … And when included at all, it would at most enhance the persistence of the impact of economic shocks that buffet the economy, delaying slightly its natural return to the steady state …”
“Economists are now trying hard to incorporate financial factors into standard macroeconomic models. However, the prevailing, in fact almost exclusive, strategy is a conservative one. It is to graft additional so-called financial “frictions” on otherwise fully well behaved equilibrium macroeconomic models, built on real-business-cycle foundations and augmented with nominal rigidities. The approach is firmly anchored in the New Keynesian Dynamic Stochastic General Equilibrium (DSGE) paradigm.”
“The purpose of this essay is to summarise what we think we have learnt about the financial cycle over the last ten years or so in order to identify the most promising way forward…. The main thesis is that …it is simply not possible to understand business fluctuations and their policy challenges without understanding the financial cycle”
There is an interesting discussion of the public policy (i.e. prudential, fiscal, monetary) associated with recognising the role of the financial cycle but I will focus on what implications this may have for bank management in general and stress testing in particular.
Insights and questions we can derive from the paper
The observation that financial crises are based on simultaneous positive deviations of the ratio of private sector credit-to-GDP and asset prices, especially property prices, from historical norms covers much the same ground as the Basel Committee’s Countercyclical Capital Buffer (CCyB) and is something banks would already monitor as part of the ICAAP. The interesting question the paper poses for me is the extent to which stress testing (and ICAAP) should focus on a “financial cycle” style disruption as opposed to a business cycle event. Even more interesting is the question of whether the higher severity of the financial cycle is simply an exogenous random variable or an endogenous factor that can be attributed to excessive credit growth.
I think this matters because it has implications for how banks calibrate their overall risk appetite. The severity of the downturns employed in stress testing has in my experience gradually increased over successive iterations. My recollection is that this has partly been a response to prudential stress tests which were more severe in some respects than might have been determined internally. In the absence of any objective absolute measure of what was severe, it probably made sense to turn up the dial on severity in places to align as far as possible the internal benchmark scenarios with prudential benchmarks such as the “Common Scenario” APRA employs.
At the risk of a gross over simplification, I think that banks started the stress testing process looking at both moderate downturns (e.g. 7-10 year frequency and relatively short duration) and severe recessions (say a 25 year cycle though still relatively short duration downturn). Bank supervisors in contrast have tended to focus more on severe recession and financial cycle style severity scenarios with more extended durations. Banks’s have progressively shifted their attention to scenarios that are more closely aligned to the severe recession assumed by supervisors in part because moderate recessions tend to be fairly manageable from a capital management perspective.
Why does the distinction between the business cycle and the financial cycle matter?
Business cycle fluctuations (in stress testing terms a “moderate recession”) are arguably an inherent feature of the economy that occur largely independently of the business strategy and risk appetite choices that banks make. However, Borio’s analysis suggests that the decisions that banks make (in particular the rate of growth in credit relative to growth in GDP and the extent to which the extension of bank credit contributes to inflated asset values) do contribute to the risk (i.e. probability, severity and duration) of a severe financial cycle style recession.
Borio’s analysis also offers a way of thinking about the nature of the recovery from a recession. A moderate business cycle style recession is typically assumed to be short with a relatively quick recovery whereas financial cycle style recessions typically persist for some time. The more drawn out recovery from a financial cycle style recession can be explained by the need for borrowers to deleverage and repair their balance sheets as part of the process of addressing the structural imbalances that caused the downturn.
If the observations above are true, then they suggest a few things to consider:
should banks explore a more dynamic approach to risk appetite limits that incorporated the metrics identified by Borio (and also used in the calibration of the CCyB) so that the level of risk they are willing to take adjusts for where they believe they are in the state of the cycle (and which kind of cycle we are in)
how should banks think about these more severe financial cycle losses? Their measure of Expected Loss should clearly incorporate the losses expected from business cycle style moderate recessions occurring once every 7-10 years but it is less clear that the kinds of more severe and drawn out losses expected under a Severe Recession or Financial Cycle downturn should be part of Expected Loss.
A more dynamic approach to risk appetite get us into some interesting game theory puzzles because a decision by one bank to pull back on risk appetite potentially allows competitors to benefit by writing more business and potentially doubly benefiting to the extent that the decision to pull back makes it safer for competitors to write the business without fear of a severe recession (in technical economist speak we have a “collective action” problem). This was similar to the problem APRA faced when it decided to impose “speed limits” on certain types of lending in 2017. The Royal Commission was not especially sympathetic to the strategic bind banks face but I suspect that APRA understand the problem.
How do shareholders think about these business and financial cycle losses? Some investors will adopt a “risk on-risk off” approach in which they attempt to predict the downturn and trade in and out based on that view, other “buy and hold” investors (especially retail) may be unable or unwilling to adopt a trading approach.
The dependence of the financial cycle on the fiscal and monetary policy regimes in place and changes in the real-economy also has potential implications for how banks think about the risk of adverse scenarios playing out. Many of the factors that Borio argues have contributed to the financial cycle (i.e. financial liberalisation under Basel II, monetary policy focussed primarily on inflation targeting and globalisation in the real economy) are reversing (regulation of banks is much more restrictive, monetary policy appears to have recognised the limitations of a narrow inflation target focus and the pace of globalisation appears to be slowing in response to a growing concern that its benefits are not shared equitably). I am not sure exactly what these changes mean other than to recognise that they should in principle have some impact. At a minimum it seems that the pace of credit expansion might be slower in the coming decades than it has in the past 30 years.
All in all, I find myself regularly revisiting this paper, referring to it or employing the distinction between the business and financial cycle. I would recommend it to anyone interested in bank capital management.
This post is irredeemably technical so stop here if that is not your interest. If you need to understand some of the mechanics of the formula used to calculate credit risk weighted assets under the advanced Internal Ratings Based (IRB) approach then the BCBS published a paper in 2005 which offers an explanation:
describing the economic foundations
as well as the underlying mathematical model and its input parameters.
While a lot has changed as a result of Basel III, the models underlying the calculation of Internal Rating Based Capital (IRB) requirements are still based on the core principles agreed under Basel II that are explained in this BCBS paper.
The notes in the linked page below mostly summarise the July 2005 paper with some emphasis (bolded text) and comments (in italics) that I have added. The paper is a bit technical but worth reading if you want to understand the original thinking behind the Basel II risk weights for credit risk.
I initially found the paper useful for revisiting the foundation assumptions of the IRB framework as background to considering the regulatory treatment of Expected Loss as banks transition to IFRS9. The background on how the RW was initially intended to cover both Expected and Unexpected Loss, but was revised such that capital was only required to cover Unexpected Loss, is especially useful when considering the interaction of loan loss provisioning with capital requirements.
Reading the BCBS paper has also been useful for thinking through a range of related issues including:
The rationale for, and impact of, prudential conservatism in setting the risk parameters used in the IRB formula
The cyclicality of a risk sensitive capital requirement (and potential for pro cyclicality) and what might be done to mitigate the risk of pro-cyclical impacts on the economy
I am not a credit risk model expert, so the summary of the paper and my comments must be read with that in mind. I did this to help me think through some of the issues with bank capital adequacy. Hopefully others will find the notes useful. If you see something wrong or something you disagree with then let me know.
This is a big topic, and somewhat irredeemably technical, but I have come to believe that there are some unique features of banks that make them quite different from other companies. Notwithstanding the technical challenges, I think it is important to understand these distinguishing features if we are to have a sensible debate about the optimum financing structure for a bank and the kinds of returns that shareholders should expect on the capital they contribute to that structure.
You could be forgiven for thinking that the Australian debate about optimum capital has been resolved by the “unquestionably strong” benchmark that APRA has set and which all of the major banks have committed to meet. However, agreeing what kind of return is acceptable on unquestionably strong capital remains contentious and we have only just begun to consider how the introduction of a Total Loss Absorbing Capital (TLAC) requirement will impact these considerations.
The three distinctive features of banks I want to explore are:
The way in which net new lending by banks can create new bank deposits which in turn are treated as a form of money in the financial system (i.e. one of the unique things banks do is create a form of money);
The reality that a large bank cannot be allowed to fail in the conventional way (i.e. bankruptcy followed by reorganisation or liquidation) that other companies and even countries can (and frequently do); and
The extent to which bank losses seem to follow a power law distribution and what this means for measuring the expected loss of a bank across the credit cycle.
It should be noted at the outset that Anat Admati and Martin Hellwig (who are frequently cited as authorities on the issues of bank capital discussed in this post) disagree with most if not all of the arguments I intend to lay out. So, if they are right, then I am wrong. Consequently, I intend to first lay out my understanding of why they disagree and hopefully address the objections they raise. They have published a number of papers and a book on the topic but I will refer to one titled “The Parade of the Bankers’ New Clothes Continues: 31 Flawed Claims Debunked” as the primary source of the counter arguments that I will be attempting to rebut. They are of course Professors whereas I bring a lowly masters degree and some practical experience to the debate. Each reader will need to decide for themselves which analysis and arguments they find more compelling.
Given the size of the topic and the technical nature of the issues, I also propose to approach this over a series of posts starting with the relationship between bank lending and deposit creation. Subsequent posts will build on this foundation and consider the other distinctive features I have identified before drawing all of the pieces together by exploring some practical implications.
Do banks create “money”? If so, how does that impact the economics of bank funding?
The Bank of England (BoE) released a good paper on the first part of this question titled “Money creation in the modern economy” . The BoE paper does require some banking knowledge but I think demonstrates reasonably clearly that the majority of bank deposits are created by the act of a bank making a new loan, while the repayment of bank loans conversely reduces the pool of deposits. The related but more important question for the purposes of this discussion is whether you believe that bank deposits are a form of money.
Admati and Hellwig identify the argument that “banks are special because they create money” as Flawed Claim #5 on the grounds that treating deposits as money is an abuse of the word “money”. They are not disputing the fact that monetary economists combine cash with demand deposits in one of the definitions of money. As I understand it, the essence of their argument is that deposits are still a debt of the issuing bank while “real” money does not need to be repaid to anyone.
It is true that deposits are a bank debt and that some deposits are repayable on demand. However, I believe the bigger issues bearing on the economics of bank financing stem from the arguments Admati and Hellwig advance to debunk what they label as Flawed Claim #4 that “The key insights from corporate finance about the economics of funding, including those of Modigliani and Miller, are not relevant for banks because banks are different from other companies“.
Their argument appears to focus on using Modigliani and Miller (“M&M”) as an “analytical approach” in which the cost (contractual or expected) of the various forms of financing are connected by a universal law of risk and reward. Their argument is that this universal law (analogous to the fundamental laws of physics) demands that using more or less equity (relative to debt) must translate to a lower or higher risk of insolvency and that rational debt investors will respond by adjusting the risk premium they demand.
I have no issue with the analytical approach or the premise that funding costs should be related to risk. What happens however when one of the primary forms of debt funding is largely protected from the risk of insolvency? In the case of the major Australian banks, deposits account for over half of a bank’s total funding but are largely isolated from the risk of insolvency by a number of features. One is the Banking Act that confers a preferred claim in favour of Australian depositors over the Australian assets of the bank. The other is government guaranteed deposit insurance coverage capped at $250,000 per person per bank. The rationale for these acts of apparent government generosity is a contentious subject in itself but, for the purposes of this post, my working hypothesis is that the preferred claim and deposit insurance are a consequence of the fact that the community treats bank demand deposits as a form of money.
Consequently, the risk that an Australian depositor will face a loss of principal in the already remote event of insolvency is arguably de minimis and the way that demand deposits are priced and the way they are used as a substitute for cash reflects this risk analysis. There remains a related, though separate, risk that a bank may face a liquidity problem but depositors (to the extent they even think about this) will assume that central bank Lender of Last Resort liquidity support covers this.
Admati and Hellwig do not, to the best of my knowledge, consider the implications of these features of bank funding. In their defence, I don’t imagine that the Australian banking system was front of mind when they wrote their papers but depositor preference and deposit insurance are not unique Australian innovations. However, once you consider these factors, the conclusion I draw is that the cost of a substantial share of a bank’s debt financing is relatively (if not completely) insensitive to changes in the amount of equity the bank employs in its financing structure.
One consequence is that the higher levels of common equity that Australian banks employ now, compared to the position prior to the GFC, has not resulted in any decline in the cost of deposit funding in the way that M&M say that it should. In fact, the more conservative funding and liquidity requirements introduced under Basel III have required all banks to compete more aggressively for the forms of deposit funding that are deemed by the prudential requirements to be most stable thereby driving up the cost.
The point here is not whether these changes were desirable or not (for the record I have no fundamental issue with the Unquestionably Strong capital benchmark nor with more conservative funding and liquidity requirements). The point is that the cost of deposit funding, in Australian banking at least, has not declined in the way that Admati and Hellwig’s analytical approach and universal law demands that it should.
Summing up, it is possible that other forms of funding have declined in cost as Admati and Hellwig claim should happen, but there is both an analytical rationale and hard evidence that this does not appear to be the case, for Australian bank deposits at least.
The next post will consider the other main (non equity) components of a bank funding structure and explore how their risk/cost has evolved in response both to the lessons that investors and rating agencies took away from the GFC and to the changes in bank regulation introduced by Basel III. A subsequent post will review issues associated with measuring the Expected Loss and hence the true “Through the Cycle” profitability of a bank before I attempt to bring all of the pieces together.
There is a lot of ground to cover yet. At this stage, I have simply attempted to lay out a case for why the cost of bank deposits in Australia has not obeyed the universal analytical law posited by Admati and Hellwig as the logical consequence of a bank holding more equity in its financing structure but if you disagree tell me what I am missing …
Post script: The arguments I have laid out above could be paraphrased as “banks deposits differ from other kinds of debt because banks themselves create deposits by lending” which Admati and Hellwig specifically enumerate as Flawed Claim #6. I don’t think their rebuttal of this argument adds much to what is discussed above but for the sake of completeness I have copied below the relevant extract from their paper where they set out why they believe this specific claim is flawed. Read on if you want more detail or have a particular interest in this topic but I think the main elements of the debate are already covered above. If you think there is something here that is not covered above then let me know.
Flawed Claim 6: Bank deposits differ from other kinds of debt because banks create deposits by lending.
What is wrong with this claim? This claim is often made in opposition to a “loanable funds” view of banks as intermediaries that collect deposits in order to fund their loans. Moreover, this “money creation through lending” is said to be the way money from the central bank gets into the economy.19 The claim rests on a confusion between stocks and flows. Indeed, if a commercial bank makes a loan to a nonfinancial firm or to a private household it provides its borrowers with a claim on a deposit account. Whereas this fact provides a link between the flow of new lending and the flow of new deposits, it is hardly relevant for the bank’s funding policy, which concerns the stocks of different kinds of debt and equity that it has outstanding, which must cover the stocks of claims on borrowers and other assets that the bank holds.
A nonfinancial firm or household that receives a loan from a bank will typically use the associated claim on a deposit account for payments to third parties. The recipients of these payments may want to put some of the money they get into deposits, but they may instead prefer to move the money out of the banking system altogether, e.g., to a money market fund or a stock investment fund. 20
From the perspective of the individual bank, the fact that lending goes along with deposit creation does not change the fact that the bank owes its depositors the full amount they deposited. The key difference between deposits and other kinds of debt is not that deposits are “like money” or that deposits may be created by lending, but rather that the bank provides depositors with services such as payments through checks and credit cards or ATM machines that make funds available continuously. The demand for deposits depends on these services, as well as the interest that the bank may offer, and it may also depend on the risk of the bank becoming insolvent or defaulting.21
The suggestion that bank lending is the only source of deposit creation is plainly false.22 Deposits are created when people bring cash to the bank, and they are destroyed when people withdraw cash. In this case, the reduction in deposits – like any reduction in funding – goes along with a reduction in the bank’s assets, i.e., a shortening of its balance sheet, but this reduction affects the bank’s cash reserves rather than its lending. The impact of such withdrawals on banks and entire banking systems are well known from the Great Depression or from the recent experience of Greece. In Greece in the spring and summer of 2015, depositors also were worried about the prospect that in the event of the country’s exit from the euro, their denomination of their deposits would be changed, whereas a stack of bills under a matrass would not be affected.