If you think bank regulation should be made much simpler it’s probably worth reading today’s Basel Committee document on bank leverage ratios, which the chairman of the Basel Committe described as “a relatively simple measure.” And what could be simpler than regulating leverage ratios?1 It’s just, like:

  • tot up all your assets, including all your creepy off-balance-sheet stuff and evil derivatives and so forth,
  • divide by your equity, and
  • take the reciprocal for some reason.

This is the theory behind proposals like the Brown-Vitter bill, which would do away with risk-based capital measures and focus on simple leverage. No risk-weighting, no monkeying with different kinds of equity, no problem. Just simple, impossible to manipulate, straightforward, easily comparable measures of how levered – and thus how risky – every bank is.

Hahaha no kidding it’s full of weird stuff:

23. Banks must calculate their derivatives exposures, including where a bank sells protection using a credit derivative, as the replacement cost (RC) for the current exposure plus an add-on for potential future exposure as described in paragraph 24 applying the regulatory bilateral netting rules as specified in paragraphs 8 to 11 of Annex 1, and adjusting the exposure amount for the related collateral as set out in paragraphs 26 to 29 below. Written credit derivatives are subject to additional treatment as set out in paragraphs 30 to 33 below.

Basel’s decisions on how to treat netting and collateral will be … controversial?2 But even just deciding how to count assets is hard enough. If you have a five-year interest-rate swap with $100mm notional that has a positive value to you of $5 million, that’s … $5.5 million of “assets” for the leverage test.3 (If its value to you is negative $5 million, it counts as $0.5mm of assets.4) If you buy protection via a five-year credit default swap with $100mm notional that has a positive value to you of $5 million, it’s $10 (IG) or $15 million (HY) of assets.5 If you sell protection via a five-year credit default swap with $100mm notional that has a positive value to you of $5 million, it’s … I think $105 million of assets?6 In any case, the answer is never $5 million: derivatives assets are never measured at what they’re worth.

This can create absurdities; consider the following two trades:

  • Trade 1: Enter five-year, $100mm at-the-money total return swap on Company X stock (you get paid any appreciation in the stock, you pay any decline in value). On my read, day one, you have $8 million of assets for Basel III leverage purposes.7
  • Trade 2: Enter five-year, $100mm at-the-money credit default swap on Company X bonds (you get paid a credit spread, you pay par minus recovery value on any default – effectively you make any improvement in creditworthiness / you lose any decline in creditworthiness). Day one, you have $100 million of assets for Basel III leverage purposes.8

I think it is self-evident that trade 1 is riskier than trade 2? Bonds tend to outrank equity, much of the time. But Basel leverage counts trade 1 as 12x less risky because, basically, people don’t like CDS, while no one really gets exercised about equity swaps.9 The arbitrage is left as an exercise for the … oh let’s try it in the footnotes.10

This is not meant to pick on Basel! I mean, again, you can complain about the netting stuff if you want. Or, from the other side, there is the view that “The methodology is overly complex in places and the prescription overly rigid.” But “overly complex” is often just a longer way of saying “complex,” and you can understand a lot of the thinking that went into these rules. You could find simpler rules than these: “count all derivatives at notional,” for instance, or “don’t count them at all.” It’s just that the tradeoff is that those rules might be kind of dumb.

Basel presses ahead with plans to limit bank borrowing [FT]
Proposed Guidelines Could Require Banks to Raise Billions in Capital [DealBook]
Consultative Document: Revised Basel III leverage ratio framework and disclosure requirements [BIS]

1. Oh, various things, if you want to get beyond capital-type regulation. The school of thought that would basically ban short-term bank debt seems to have had a revival, with flavors from John Cochrane, Matt Klein, Morgan Ricks. My instinctive sympathies are with Arnold Kling – “the nonfinancial sector wants to issue risky liabilities and hold safe assets, and the financial sector accommodates this by doing the reverse” – but, sure, whatever. There is some prospect that bank funding regulation would be simpler than bank capital regulation.

2. Collateral basically doesn’t count:

Collateral received in connection with derivative contracts does not reduce the economic leverage inherent in a bank’s derivatives position. In particular, the exposure arising from the contract underlying is not reduced. As such, collateral received (cash or non-cash) may not be netted against derivatives exposures whether or not netting is permitted under the bank’s operative accounting or risk-based framework. When calculating the exposure amount by applying paragraphs 23 to 25 above, a bank must not reduce the exposure amount by any collateral received from the counterparty. Furthermore, the replacement cost (RC) must be grossed up by any collateral amount used to reduce its value, including when collateral received by a bank has reduced the derivatives assets reported on-balance sheet under its operative accounting framework.

The theory being that collateral “reduces counterparty exposure” but also “increase[s] the economic resources at the disposal of the bank, as the bank can use the collateral to leverage itself.” So it’s sneaky leverage.

As for netting, if you’ve got a $100 asset and a $95 liability with the same counterparty, is that $100 of assets, or $5? That is a vexed question. Basel comes down on the side of $100 unless you’ve got a bilateral netting agreement “that creates a single legal obligation, covering all included transactions, such that the bank would have either a claim to receive or obligation to pay only the net sum of the positive and negative mark-to-market values of included individual transactions in the event a counterparty fails to perform due to any of the following: default, bankruptcy, liquidation or similar circumstances;” and “written and reasoned legal opinions that, in the event of a legal challenge, the relevant courts and administrative authorities would find the bank’s exposure to be such a net amount under: the law of the jurisdiction in which the counterparty is chartered and, if the foreign branch of a counterparty is involved, then also under the law of jurisdiction in which the branch is located; the law that governs the individual transactions; and the law that governs any contract or agreement necessary to effect the netting.” I feel like you could find a way to get those opinions but it seems daunting?

3. See paragraph 24 (Total Exposure = mark-to-market (if positive) + add-on, where add-on is an add-on factor (from the appendix) times notional. Paragraph 1 of the appendix has this table:

4. See above; if the mark-to-market is negative you would seem to zero it and just use the add-on.

5. The single-name CDS add-on table is paragraph 3 of the appendix:

So $5mm of mark-to-market and 5 or 10% of notional for add-on, depending on whether it’s “qualifying” (basically: “securities issued by public sector entities and multilateral development banks, plus other securities that are rated investment-grade …” etc.) or not.

6. Paragraphs 30-32:

30. Additional treatment for written credit derivatives: written credit derivatives create a notional credit exposure arising from the creditworthiness of the reference entity, in addition to the counterparty credit exposure arising from the fair value of contracts. The Committee believes that it is appropriate to treat written credit derivatives consistently with cash instruments (eg loans, bonds) for the purposes of the Exposure Measure.

31. In order to capture the credit exposure to the reference entity, in addition to the above treatment for derivatives and related collateral, the full effective notional value referenced by a written credit derivative is to be incorporated into the Exposure Measure. The effective notional amount of a written credit derivative may be reduced by the effective notional amount of a purchased credit derivative on the same reference name and level of seniority if the remaining maturity of the purchased credit derivative is equal to or greater than the remaining maturity of the written credit derivative.

32. The treatment described in paragraph 31 recognises a difference between cash instruments and credit derivatives; namely that a bank closes a long cash position by selling the position, whereas with a credit derivative, a bank generally closes a long position by entering into an offsetting derivative transaction. Therefore, this treatment allows a bank which purchases credit protection on the same reference name on which it sold credit protection to net the bought and sold protection to reduce its Exposure Measure.

So $5mm of positive MTM plus $100mm for notional, it seems? (Is this double-counting? The theory seems to be that (1) you have credit exposure to your counterparty on the $5mm mark to you and (2) you have credit exposure to the underlying on the $100mm notional. Though: never at the same time, right?

7. See above: zero mark-to-market plus 8% of notional for add-on.

8. See above: zero mark-to-market plus 100% of notional for being a written credit derivative.

9. Like, the paper says (paragraph 30) “The Committee believes that it is appropriate to treat written credit derivatives consistently with cash instruments (eg loans, bonds) for the purposes of the Exposure Measure,” which is fair enough, but of course equity total return swaps are also equivalent to cash instruments (stocks) for purposes of economic exposure. Just not this particular measure of exposure.

10. I mean, what do I know, but I feel like I’d sketch it something like:

  • Create Box.
  • Box writes $100mm CDS on Underlying to Counterparty.
  • Non-Capital-Constrained Intermediating Shadow Bank capitalizes Box with $100mm of equity, which it funds with an IOU.
  • Bank writes total return swap to NCCISB on equity of Box.
  • Box marks its CDS to market, Bank marks its total return swap to market, and Box’s equity value is straightforwardly just $100mm plus or minus changes in the fair value of the CDS (meaning that the total return swap’s value is just plus or minus the changes in the fair value of the CDS).
  • Bank posts collateral to NCCISB on its total return swap, which NCCISB contributes/lends/whatever to Box, which Box posts as collateral on the CDS.
  • And vice versa (if CDS moves against Counterparty, it posts to Box, which sends it to NCCISB, which posts to Bank).
  • Counterparty now has a CDS on Underlying, backed by the credit of Bank.
  • Bank has written an equity total return swap with the economic characteristics of the CDS, but with only an 8% instead of 100% day-one effect on leverage.
  • Non-Capital-Constrained Intermediating Shadow Bank has a nothing, for which it gets paid a fee.

Obviously you’d need to clean up the bankruptcy remoteness of NCCISB (like, really, you want an Intermediate Box between Box and NCCISB, to be the swap counterparty and so forth, so no one is looking to NCCISB as a credit). But: thoughts? Am I missing something or misreading the thing, or does this basically work?

5 comments (hidden to protect delicate sensibilities)
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Comments (5)

  1. Posted by Guest 5 | June 26, 2013 at 5:44 PM

    So you could get paid money for writing a bunch of derivatives with negative replacement costs and not have them count towards assets? That seems pretty gameable.

  2. Posted by Avid Reader | June 26, 2013 at 6:31 PM

    I love your box, Matt. But doesn't the NCCISB actually write the TRS on Box equity to Bank (so the Bank gets any positive equity value from the Box/funds the $100m purchase of debt if CDS triggers)?

    Plus yeah, tidy up that stuff. Your NCCISB credit risk is showing.

  3. Posted by Poor Matt | June 26, 2013 at 10:19 PM

    10 footnotes and only two (now three) comments. I feel bad for Matt when he has more footnotes than comments.

  4. Posted by Doofus | June 26, 2013 at 10:25 PM

    I'm so glad there's at least one other person besides me who gets exercised over the BCBS.

  5. Posted by sohbet | March 29, 2014 at 5:38 PM

    WInklevoss Twins, Bitcoins, and ETF's. This is a prewritten Saturday Night Live Parody.