Pro cyclicality – From the outside

Margin calls …

… seem to be on the increase.

This post by Marc Rubinstein offers a short but detailed summary of what has been going on, why and what it means for markets. Read the whole post but one of the key issues for me is increased procyclicality…

The drawback of a heavily collateralized market, though, is its tendency to inject procyclicality into the system. Periods of market turbulence can drive sharply higher collateral requirements, which can prompt more turbulence if that leads to forced selling – such as we saw in the UK last week.
Marc Rubinstein, “Net Interest” Blog – 8 October 2022

Tony – From the Outside

Predicting phase transitions

I am not sure the modelling methodology described in this article is quite as good as the title suggests…

“Chaos Researchers Can Now Predict Perilous Points of No Return”

… but it would be very interesting if it lives up to the claims made in the article. It is a quick read and the subject matter seems worth keeping an eye on.

Here are two short extracts to give you a flavour of the claims made

A custom-built machine learning algorithm can predict when a complex system is about to switch to a wildly different mode of behavior.

In a series of recent papers, researchers have shown that machine learning algorithms can predict tipping-point transitions in archetypal examples of such “nonstationary” systems, as well as features of their behavior after they’ve tipped. The surprisingly powerful new techniques could one day find applications in climate science, ecology, epidemiology and many other fields.

Tony – From the Outside

Bank capital adequacy – APRA chooses Option 2

APRA released a discussion paper in August 2018 titled “Improving the transparency, comparability and flexibility of the ADI capital framework” which offered two alternative paths.

One (“Consistent Disclosure”) under which the status quo would be largely preserved but where APRA would get involved in the comparability process by adding its imprimatur to the “international harmonised ratios” that the large ADIs use to make the case for their strength compared to their international peers, and
A second (“Capital Ratio Adjustments”) under which APRA would align its formal capital adequacy measure more closely with the internationally harmonised approach.

I covered those proposals in some detail here and came out in favour of the second option. I don’t imagine APRA pay much attention to my blog but in a speech delivered to the AFR Banking and Wealth Summit Wayne Byres flagged that APRA do in fact intend to pursue the second option.

The speech does not get into too much detail but it listed the following features the proposed new capital regime will exhibit:

– more risk-based – by adjusting risk weights in a range of areas, some up (e.g. for higher risk housing) and some down (e.g. for small business);
– more flexible – by changing the mix between minimum requirement and buffers, utilising more of the latter;
– more transparent – by better aligning with international minimum standards, and making the underlying strength of the Australian framework more visible;
– more comparable – by, in particular, making sure all banks disclose a capital ratio under the common, standardised approach; and
– more proportionate – by providing a simpler framework suitable for small banks with simple business models.

… while also making clear that

… probably the most fundamental change flowing from the proposals is that bank capital adequacy ratios will change. Specifically, they will tend to be higher. That is because the changes we are proposing will, in aggregate, reduce risk-weighted assets for the banking system. Given the amount of capital banks have will be unchanged, lower risk-weighted assets will produce higher capital ratios.
However, that does not mean banks will be able to hold less capital overall. I noted earlier that a key objective is to not increase capital requirements beyond the amount needed to meet the ‘unquestionably strong’ benchmarks. Nor is it our intention to reduce that amount. The balance will be maintained by requiring banks to hold larger buffers over their minimum requirements.

One observation at this stage …

It is hard to say too much at this stage given the level of detail released but I do want to make one observation. Wayne Byres listed four reasons for the changes proposed;

To improve risk sensitivity
To make the framework more flexible, especially in times of stress
To make clearer the fundamental strength of our banking system vis-a-vis international peers
To ensure that the unquestionably strong capital built up prior to the pandemic remains a lasting feature of the Australian banking system.

Pro-cyclicality remains an issue

With respect to increasing flexibility, Wayne Byres went on to state that “Holding a larger proportion of capital requirements in the form of capital buffers main that there is more buffer available to be utilised in times of crisis” (emphasis added).

It is true that the capital buffer will be larger in basis points terms by virtue of the RWA (denominator in the capital ratio) being reduced. However, it is also likely that the capital ratio will be much more sensitive to the impacts of a stress/crisis event.

This is mostly simple math.

I assume that loan losses eating into capital are unchanged.
It is less clear what happens to capital deductions (such as the CET1 deduction for Regulatory Expected Loss) but it is not obvious that they will be reduced.
Risk Weights we are told will be lower and more risk sensitive.
The lower starting value for RWA in any adverse scenario means that the losses (we assume unchanged) will translate into a larger decline in the capital ratio for any given level of stress.
There is also the potential for the decline in capital ratios under stress to be accentuated (or amplified) to the extent the average risk weights increase in percentage terms more than they would under the current regime.

None of this is intended to suggest that APRA has made the wrong choice but I do believe that the statement that “more buffer” will be available is open to question. The glass is however most definitely half full. I am mostly flagging the fact that pro-cyclicality is a feature of any risk sensitive capital adequacy measure and I am unclear on whether the proposed regime will do anything to address this.

The direction that APRA has indicated it intends to take is the right one (I believe) but I think there is an opportunity to also address the problem of pro-cyclicality. I remain hopeful that the consultation paper to be released in a few weeks will shed more light on these issues.

Tony – From the Outside

p.s. the following posts on my blog touch on some of the issues that may need to be covered in the consultation

The case for lower risk weights
A non zero default for the counter cyclical capital buffer
The interplay of proposed revisions to APS 111 and the RBNZ requirement that banks in NZ hold more CET1 capital
Does expected loss loan provisioning reduce pro-cyclicality
My thoughts on a cyclical capital buffer

RBNZ COVID 19 Stress Tests

The RBNZ just released the results of the stress testing conducted by itself and a selection of the larger NZ banks to test resilience to the risks posed by COVID 19.

The extract below summarises the process the RBNZ followed and its key conclusions:

 COVID-19 stress test consisted of two parts. First, a desktop stress test where the Reserve Bank estimated the impact on profitability and capital for nine of New Zealand’s largest banks to the impact of two severe but plausible scenarios. Second, the Reserve Bank coordinated a process in which the five largest banks used their own models to estimate the effect on their banks for the same scenarios.
 The pessimistic baseline scenario can be characterised as a one-in-50 to one-in-75 year event with the unemployment rate rising to 13.4 percent and a 37 percent fall in property prices. In the very severe scenario, the unemployment rate reaches 17.7 percent and house prices fall 50 percent. It should be noted that these scenarios are hypothetical and are significantly more severe than the Reserve Banks’ baseline scenario.
 The overall conclusion from the Reserve Bank’s modelling is that banks could draw on their existing capital buffers and continue lending to support lending in the economy during a downturn of the severity of the pessimistic baseline scenario. However, in the more severe scenario, banks capital fell below the regulatory minimums and would require significant mitigating actions including capital injections to continue lending. This reinforces the need for strong capital buffers to provide resilience against severe but unlikely events.
 The results of this stress test supports decisions that were made as part of the Capital Review to increase bank capital levels. The findings will help to inform Reserve Bank decisions on the timing of the implementation of the Capital Review, and any changes to current dividend restrictions.
“Outcome from a COVID-19 stress test of New Zealand banks”, RBNZ Bulletin Vol 83, No 3 September 2020

I have only skimmed the paper thus far but there is one detail I think worth highlighting for anyone not familiar with the detail of how bank capital adequacy is measured – specifically the impact of Risk Weighted Assets on the decline in capital ratios.

The RBNZ includes two useful charts which decompose the aggregate changes in CET1 capital ratio by year two of the scenario.

RBNZ Desktop Results – Pessimistic Baseline Scenario

In the “Pessimistic Baseline Scenario”(PBS), the aggregate CET1 ratio declines 3.7 percentage points to 7.7 percent. This is above both the regulatory minimum and the threshold for mandatory conversion of Additional Tier 1 Capital. What I found interesting was that RWA growth contributed 2.2 percentage points to the net decline.

The RBNZ quite reasonably points out that banks will amplify the downturn if they restrict the supply of credit to the economy but I think it is also reasonable to assume that the overall level of loan outstandings is not growing and may well be shrinking due to the decline in economic activity. So a substantial portion of the decline in the aggregate CET1 ratio is due to the increase in average risk weights as credit quality declines. The C ET1 ratio is being impacted not only by the increase in impairment expenses reducing the numerator, there is a substantial added decline due to the way that risk weighted assets are measured

RBNZ Desktop Results – Very Severe Scenario

In the “Very Severe Scenario”(VSS), the aggregate CET1 ratio declines 5.6 percentage points to 5.8 percent. The first point to note here is that CET1 only remains above the 4.5% prudential minimum by virtue of the conversion of 1.6 percentage points of Additional Tier 1 Capital. Assuming 100% of AT1 was converted, this also implies that the Tier 1 ratio is below the 6.0% prudential minimum.

These outcomes provide food for thought but I few points I think wroth considering further before accepting the headline results at face value:

The headline results are materially impacted by the pro cyclicality of the advanced forms of Risk Weighted Asset measurement – risk sensitive measures offer useful insights but we also need to understand they ways in which they can also amplify the impacts of adverse scenarios rather than just taking the numbers at face value
The headline numbers are all RBNZ Desktop results – it would be useful to get a sense of exactly how much the internal stress test modelling conducted by the banks varied from the RBNZ Desktop results – The RBNZ stated (page 12) that the bank results were similar to its for the PBS but less severe in the VSS.

As always, it is entirely possible that I am missing something but I feel that the answer to bank resilience is not just a higher capital ratio. A deeper understanding of the pro cyclicality embedded in the system will I think allow us to build a better capital adequacy framework. As yet I don’t see this topic getting the attention it deserves.

Tony – From the Outside

Capital adequacy reform – what we have learned from the crisis

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tony – From the Outside

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

Thinking aloud about Australian bank ROE

I have been wanting to put something down on the question of Australian major bank ROE for a while. The issue generates a lot of heat but the public discussion I have observed has been truncated, in my opinion, by misconceptions.

I think we can agree that banks need to be profitable to be healthy and a healthy banking system underpins the health of the economy as a whole. Excessive profitability however is clearly bad for consumers, business and for the economy as a whole. The problem is determining what level of profitability is excessive. This post is unlikely to be the final word on this topic but hopefully it introduces a couple of considerations that seem to me to be largely missing from the public debate.

Most of what I read on this topic seems to treat the ROE of the Australian majors as self evidently excessive and focuses on what to do about it. Exhibit A is the reported ROE which in the 2019 half year updates varied from 10.05% to 14.10%. This is much less than it was but still substantially better than what is being achieved by most banks outside Australia and by the smaller local banks. Exhibit B is the fact that the Australian banking system is an oligopoly which almost by definition earn excess profits.

Reported ROE exceeds COE – case closed

Any discussion of ROE must be anchored by the estimated Cost of Equity (COE), the minimum return that investors require to hold equity risk. There are a variety of ways of calculating this but all of them generate a number that is much less than the ROE the majors currently earn. So case closed.

There is no question that the Australian majors cover their cost of equity, but it is less clear to me that the margin of excess profitability is as excessive as claimed.

Corporate finance 101 teaches us that we can derive a company’s cost of equity using the Capital Asset Pricing Model (CAPM) which holds that the required return is equal to the Risk Free Return plus the Equity Risk Premium (ERP) multiplied by the extent to which the return the individual stock is correlated with the market as a whole. The general idea of being paid a premium for taking on equity risk makes sense but there are a bunch of issues with the CAPM once you get into the detail. One of the more topical being what do you do when the risk free rate approaches zero.

I don’t want to get into the detail of those issues here but will assume for the purposes of this post that a rate of return in the order of 8-10% can be defended as a minimum acceptable return. I recognise that some of the more mechanical applications of the CAPM might generate a figure lower than this if they simply apply a fixed ERP to the current risk free rate.

Two reasons why a simple comparison of ROE and COE may be misleading

Banking is an inherently cyclical business and long term investors require a return that compensates them for accepting this volatility in returns.
Book value does not define market value

Banking is a highly cyclical business – who knew?

It is often asserted that banking is a low risk, “utility” style business and hence that shareholders should expect commensurately low returns. The commentators making these assertions tend to focus on the fact that the GFC demonstrated that it is difficult (arguably impossible) to allow large banks to fail without imposing significant collateral damage on the rest of the economy. Banks receive public sector support to varying degrees that reduces their risk of failure and hence the risk to shareholders. A variation of this argument is that higher bank capital requirements post the GFC have reduced the risk of investing in a bank by reducing the risk of insolvency.

There is no question that banks do occupy a privileged space in the economy due to the central bank liquidity support that is not available to other companies. This privilege (sometimes referred to as a “social licence”) is I think an argument for tempering the kinds of ROE targeted by the banks but it does not necessarily make them a true utility style investment whose earnings are largely unaffected by cyclical downturns.

The reality is that bank ROE will vary materially depending on the state of the credit cycle and this inherent cyclicality is probably accentuated by accounting for loan losses and prudential capital requirements. Loan losses for Australian banks are currently (October 2019) close to their cyclical low points and can be expected to increase markedly when the economy eventually moves into a downturn or outright recession. Exactly how much downside in ROE we can expect is open to debate but history suggests that loan losses could easily be 5 times higher than what we observe under normal economic conditions.

There is also the issue of how often this can be expected to happen. Again using history as a guide for the base rate, it seems that downturns might be expected every 7-10 years on average and long periods without a downturn seem to be associated with increased risk of more severe and prolonged periods of reduced economic activity.

What kind of risk premium does an investor require for this cyclicality? The question may be academic for shareholders who seek to trade in and out of bank stocks based on their view of the state of the cycle but I will assume that banks seek to cater to the concerns and interests of long term shareholders. The answer for these shareholders obviously depends on how frequent and how severe you expect the downturns to be, but back of the envelope calculations suggest to me that you would want ROE during the benign part of the credit cycle to be at least 200bp over the COE and maybe 300bp to compensate for the cyclical risk.

Good risk management capabilities can mitigate this inherent volatility but not eliminate it; banks are inherently cyclical investments on the front line of the business cycle. Conversely, poor risk management or an aggressive growth strategy can have a disproportionately negative impact. It follows that investors will be inclined to pay a premium to book value for banks they believe have good risk management credentials. I will explore this point further in the discussion of book value versus market value.

Book Value versus Market Value

Apart from the cyclical factors discussed above, the simple fact that ROE is higher than COE is frequently cited as “proof” that ROE is excessive. It is important however to examine the unstated assumption that the market value of a bank should be determined by the book value of its equity. To the best of my knowledge, there is no empirical or conceptual basis for this assumption. There are a number of reasons why a company’s share price might trade at a premium or a discount to its book value as prescribed by the relevant accounting standards.

The market may be ascribing value to assets that are not recognised by the accounting standards.The money spent on financial control and risk management, for example, is largely expensed and hence not reflected in the book value of equity. That value however becomes apparent when the bank is under stress. These “investments” cannot eliminate the inherent cyclicality discussed above but they do mitigate those risk.

A culture built on sound risk management and financial control capabilities is difficult to value and won’t be reflected in book value except to the extent it results in conservative valuation and provisioning outcomes. It is however worth something. Investors will pay a premium for the banks they believe have these intangible strengths while discounting or avoiding altogether the shares of banks they believe do not.

Summing up …

This post is in no way an exhaustive treatment of the topic. Its more modest objective was simply to offer a couple of issues to consider before jumping to the conclusion that the ROE earned by the large Australian banks is excessive based on simplistic comparisons of point in time ROE versus mechanical derivations of the theoretical COE.

As always, it is entirely possible that I am missing something – if so let me know what it is ….

Tony

Is the financial system as resilient as policymakers say?

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

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

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

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

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

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

How resilient is the financial system?

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

We could quibble over details:

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

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

How should we respond (in principle)?

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

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

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

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

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

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

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

A “Money-Credit Constitution”

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

A Money-Credit Constitution defined:

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

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

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

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

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

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

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

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

Strategy 1: Crisis prevention (or mitigation at least)

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

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

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

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

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

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

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

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

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

Strategy 2a: Integrate LOLR with liquidity policy.

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

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

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

Tucker is not however completely convinced by this approach:

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

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

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

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

Tucker sets out his argument for structural subordination as follows.

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

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

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

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

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

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

Summing up …

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

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

Tony

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

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