Banks Getting Less Risky And/Or More Tricksy

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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.

Yay. Here's what that looks like as of June 2012 - again, this thing is on a nine-month delay for some reason, so that's the latest:

(Group 1 banks are 101 internationally active banks with at least €3bn in Tier 1 capital; Group 2 banks are smaller.) This is indeed an improvement over the last version, from December 2011, where, just to focus you on the Group 1 banks:

Average common equity tier 1 ratios have improved from 7.7% to 8.5% in six months; capital shortfalls have gone from €374bn to €208bn.

The CET1 ratio is of course common equity tier 1 capital divided by risk-weighted assets, so you might ask: did this come from (1) increasing capital (by retaining earnings etc.), (2) reducing assets (by selling assets and shuttering businesses), or (3) reducing the risk-weighting of assets (by rotating into safer assets and/or more optimistic models)?

You can math that out a bit using the leverage-ratio data also contained in the reports: in December 2011, the average Group 1 Basel III Tier 1 leverage ratio (Basel III Tier 1 capital divided by total assets) was 3.5%, with a denominator of €64.5 trillion; in June 2012, it was 3.7% on €67.1 trillion. Some quick math suggests that: the big banks added €2.6 trillion in total assets, but only €318 billion in risk-weighted assets, reducing their RWAs-to-total-assets ratio by over 100 basis points.1

This means that of the ~70bps in capital-ratio improvement between the end of 2011 and the middle of 2012, about two-thirds came from adding capital (mainly through retained earnings) and about one-third came from improving the mix of risk-weighted assets to total assets. Or to look at it another way: if banks had added assets with the same risk-weighting as their blended assets in December 2011, they'd have €800bn+ more in risk-weighted assets than they do now, and would need at least €57bn more in capital.

So banks are putting their money in less risky places? Or ... the other thing? We've talked a bit about RWA-model optimization, in which banks tweak their models to achieve more favorable risk weighted asset results, and how that can lead to odd results. That December-2011-to-June-2012 period coincides nicely with one of the more famous recent instances of tweaking:

In December 2011, the [JPMorgan] CIO came up with a plan to change its risk models. It estimated that by calculating risk differently, the bank could reduce its risk-weighted assets by $7 billion - more than half the targeted amount - without having to actually sell the securities.

Then some occurrences transpired. That $7 billion is a drop in the bucket to the €800bn+ RWA reduction over that period, but that's just one office at one bank. I dunno. Feel free to be suspicious.

One other thing to maybe ponder is this:

As that cetacean CIO well knew (and tweaked), one flavor of RWA-model input is value-at-risk, and one key input into VaR is volatility, and ... volatility in the first half of 2012 was low. Lower than in 2011, and way lower than in 1H2009 (which might have been the period rolling off in a three-year VaR model). Even without any model tweaks RWAs might settle to a lower point just because volatility was getting lower. Nothing nefarious about that, but a story of "banks have done lots of capital-raising and asset-shedding" is perhaps more encouraging than one of "bank capital requirements are less because recent markets have been unusually calm." Particularly if that latter story comes with a nine-month lag.

Results of the Basel III monitoring exercise as of 30 June 2012 [BIS]

Banks Make Progress on Capital Targets [WSJ]

JPMorgan and other banks tinker with risk models [Reuters]

1.The Group 2 banks seem to have shrunk, whether measured by total assets, RWAs or capital. The sample size is different and I'm not sure if that's due to sampling differences or actual bank demises, but you could I suppose cautiously read this as a story of assets moving from small banks to bigger ones. Which I guess is sensible what with the TBTF and all.


Let's Talk About: Basel III

The Fed last night unleashed eight zillion pages of Basel III implementation on the universe and I'm tempted to be like "open thread, tell us about your hopes and fears for capital regulation." So do that! Or don't because it is super boring, that is also a valid approach. Still I guess we should discuss. Starting slow though. Banks have to have capital, meaning that they have to fund some of their assets with things that are long-lived and loss-absorbing, like common equity, rather than with things that have to be paid back soon and at face value. The reason for this is that the rest of banks' assets are funded with things that we really do want to be paid back soon and at face value, like deposits, and if the value of those assets declines you don't want those deposits to be wiped out. The rules say that you need capital equal to a percentage of your assets. The game is deciding (1) what that percentage is, (2) what is capital (proceeds from selling common stock, and actual earnings, yes, but, like, deferred tax assets?), and (3) how you count assets (you might want more capital to shield you from losses in, say, social media stocks than you would to shield you from losses in Treasury bonds, so regulators use "risk-weighted assets," so that $1 of corporate bonds counts as $1 of assets, $1 of Treasuries counts as $0 of assets, and $1 of Facebook stock counts as $3 of assets*). Anyway, here are the required capital levels: