US banking regulators have released new proposals to require banks to have higher leverage ratios, counterintuitively meaning lower leverage, and you can go read them here, or read about them here or here. Briefly: in addition to regular Basel III risk-based capital requirements, banks are also subject to a backstop equity-divided-by-assets0 leverage test, and internationally the minimum is 3%, but in the US it’ll be 5% for the biggest bank holding companies and 6% for the biggest insured banks. The OCC estimates that the banks are in total about $84 billion or so short of that requirement, though they have five years to get there, so it’s not, like, go sell $84 billion of stock right now or whatever.1
It’s become fashionable to make fun of the Basel risk-based capital rules for being overly complicated and subject to gamesmanship. “Why should we risk-weight assets at all?” people ask, for some reason. “Just look at simple leverage and assume that all assets are equally risky!” Sure okay. The problems with treating all risks the same seem too self-evident to be worth discussing (though we have!) but on the other hand I challenge you to read Friday’s Basel Regulatory Consistency Assessment Programme report on the “Analysis of risk-weighted assets for credit risk in the banking book” without feeling a bit of sympathy for the simple-leverage crowd.
Not because the report is complicated, particularly? It’s actually pretty straightforward in concept. Basel II and III allow big banks to use the internal ratings-based approach to credit risk, in which the risk-weighting of a bank’s loans,1 and thus the bank’s capital requirements, are determined by the bank applying its own internal models to determine the credit risk of its borrowers. So to calibrate that system, the Baselisks went out and asked a bunch of banks to give them the probability of default that they assigned to a bunch of sovereign, financial, and corporate borrowers. Lo and behold some banks assigned different probabilities of default to some borrowers than others did and so you get somewhat head-scratching charts like this one: Read more »
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: Read more »
Bloomberg this week had an article about how bespoke synthetic CDOs are coming back in vogue, and various people have fretted about that, because synthetic CDOs are scary, financial crisis, etc. And, sure, it’s certainly possible that the next financial crisis will be exactly like the last, only with more Cyprus.1 But today let’s talk about something tangentially related.
If you require banks to have capital based on risk-weighted assets, and if capital is expensive (at least for bankers), then you’ll have banks who want to lower the risk weights of their assets. There are many ways to do this, including buying safer assets, selling riskier assets, monkeying with models, etc., but one popular way is to buy credit protection against risky assets. The reason that this is popular is because of regulatory discontinuities: if you have $100 worth of stuff with a 200% risk weight, then you have $200 of risk-weighted assets, but if you buy protection against the riskiest $10 of it then you might go from $200 of risk-weighted assets all the way to $6.30, because the safest $90 of it might have only a 7% risk weight.
That’s a big jump. If your aim is to have capital equal to 12% of your risk-weighted assets, then your capital requirements go from $24 to like 75 cents. If your cost of capital is 10%, then that jump saves you $2.32 a year. So you could pay, say, $2 a year to the protection provider and still be up a few cents, versus not buying credit protection – plus, of course, you’ve got credit protection (meaning that you get more money back if there are defaults). And if you pay $2 a year for five years to protect $10 worth of risk, then the protection provider should do that trade all day long: he’s getting paid $10 to take $10 of risk. At worst – if 10% of your stuff, or for that matter all of your stuff, defaults – he breaks even. It’s free money.
That’s oversimplified (time value, counterparty risk, whatever), but it’s kind of a thing. To some extent that thinking underlies things like the glorious Credit Suisse PAF2 trade, where Credit Suisse basically wrote credit protection to itself because doing so saved it so much on risk-weighted assets. But the folks on the Basel Committee on Banking Supervision don’t particularly like it, and so they released a document today yelling at banks about it. Read more »
It’s a good day to be wholly cynical about banks so let’s be mean to the Basel III monitoring exercise. This is a thing where periodically the BIS looks into how far away banks are from meeting their Basel III capital requirements, with about a nine-month lag. The answer is always “pretty far away,” which isn’t that big a deal since they have until 2019 to get there, but the good news today is it’s getting less far away:
On Tuesday, the Basel Committee said the average capital ratio of 101 large banks was 8.5%. In total, large banks—defined as having Tier 1 capital in excess of €3 billion ($3.89 billion)—need to raise €208.2 billion in capital to hit the ratio of 7%, which includes an extra buffer against financial shocks.
This shortfall has decreased by €175.9 billion since a similar test was conducted using data as of Dec. 31, 2011. The committee noted that these 101 large banks generated €379.6 billion of pretax profit between July 2011 and June 2012. Instead of being redistributed in pay and dividends, profit can be stored to boost capital reserves.
Banks are opaque, or so I hear, and so the only way many people can stand to be around them is if they can have some sort of number to serve as a flashlight into all that opacity. One of the big numbers is Basel III risk-weighted assets, which are intended to, as the name says, measure how much stuff a bank holds, weighted by the riskiness of the stuff. RWAs are related to another popular number – they are in many cases calculated based on value-at-risk models – and they determine capital requirements: the more risky assets you have, the more long-term loss-absorbing funding you need to have, to insulate you from loss if the risks come true.
All numbers deceive, though, and many people have noted that RWAs vary wildly across banks, with some banks reporting much lower RWAs per total account assets than others without any obvious decrease in risk. And since RWAs are based in large part on internal models, there is some suggestion that banks optimize their models to reduce RWAs. So risk-weighted assets don’t have any obvious correlation with (1) risk or (2) assets.
Which seems bad, as a first cut, but maybe isn’t: not having an obvious correlation doesn’t mean there’s no correlation. RWA critics are just looking at public information, and public information is, as noted, opaque. Maybe all the banks really are consistently and conscientiously measuring the riskiness of their assets, and just happen to hold different assets. Which is why it’s nice that the confab of bank regulators at the Bank of International Settlements went and issued a report on consistency of risk-weighted assets for market risk.1 The authors of this report, between them, regulate pretty much every big bank in the world. So they could go look at each bank’s trading book, see what assets they have, see how they risk weight them, and compare that to how other banks weight them, done.2
Financial innovation gets kind of a bad rap, and one of my favorite parts of this job is when I get to celebrate it just for being itself. Sometimes this means breathtaking magic like the derivative on its derivatives that Credit Suisse sold to itself, or elegant executions of classic ideas like the Coke shares that SunTrust sold for regulatory purposes but not for tax purposes. Other times it’s a more prosaic combination of already-existing building blocks to allow people who were comfortably doing something to keep comfortably doing it in the face of regulations designed to make it more uncomfortable.
Yesterday a reader pointed me to a Bond Buyer article that, while perhaps neither all that scandalous nor all that beautiful, is sort of cozy. It’s about a new issue of callable commercial paper issued by a Florida municipal financing commission, and here’s the joke:
JPMorgan came up with the new product as a solution for variable-rate municipal issuers facing impending Basel III regulatory problems. The proposed regulations would require banks to have a certain higher value of highly liquid assets to be available to turn into cash to meet liquidity commitments that could be drawn within 30 days. Maintaining higher liquidity would be expensive for banks, which may try to pass on costs to its issuers, according to an analyst at Moody’s Investors Service. “What we did, starting over a year ago, is ask what we can do to change the product that will still work for all the players, including issuers, investors, and the rating agencies,” Lansing said. “And the ultimate result was this product.” The new product allows banks to continue to support variable-rate products after the regulations are implemented. The paper has a variable length of maturity, but always at least 30 days. Several days before the paper would have 30 days left to its maturity, the issuer calls the paper.
The joke isn’t that funny, though I giggled at the phrase “a solution for variable-rate municipal issuers facing impending Basel III regulatory problems.” Municipal issuers face no Basel III problems: municipalities are not subject to Basel III. Read more »