Mitigating systemic risk

The Counter party Risk Management Policy Group (CRMPG) is an influential self regulatory authority that is concerned with the identification, measurement and control of counterparty risk. The group’s August 2008 report provides valuable inputs on dealing with risk in an increasingly complex global financial system. The following summary outlines the approach suggested by the CRMPG.

It is difficult for the senior management of large banks to fully grasp the scale and complexity of these control and risk management challenges. But there are certain relatively simple, core precepts that can facilitate the management and supervision of large integrated financial intermediaries and ensure that risk controls are both robust and flexible over business and credit cycles.

Precept I: The Basics of Corporate Governance
The culture of corporate governance at individual financial institutions can have a very large bearing on how individual institutions respond to unstable periods/crisis.

Risk monitoring and risk management must not be based totally on backward looking quantitative risk metrics. Instead risk management must rely heavily on judgment, communication and coordination, spanning the organization and reaching to the highest levels of management.

Sound corporate governance can help to break down the silo mentality and ensure that critical information on risk profiles, institution-wide exposure and potential channels of contagion are regularly monitored at all levels.

Critical control personnel in such areas as risk monitoring, credit, operations, internal audit, compliance and controllers must be truly independent from front-line business unit personnel. Support and control functions must be equipped and empowered to impose necessary checks and balances across all risk- taking business units. High-potential individuals must be rotated between business units and support/control functions. Incentives must be designed to discourage short-run excesses in risk taking.

Precept II: The Basics of Risk Monitoring
Risk management models and metrics will be effective only if individual institutions are able to monitor all positions and risk exposures on a timely basis. All large integrated financial intermediaries must have the capacity to monitor risk concentrations and exposures, to all institutional counterparties in a matter of hours. The operating staff must provide effective and coherent reports to senior management regarding such exposures to high-risk counterparties.

Precept III: The Basics of Estimating Risk Appetite
Estimating risk appetite and finding an adequate risk-reward balance must be a dynamic process that takes into account both qualitative and quantitative factors. Stress tests and other quantitative tools are necessary, but not sufficient, tools for making judgments about risk appetite. Stress tests can never anticipate how future events will unfold unless such tests are so extreme as to postulate outcomes that no level of capital or liquidity will provide protection against potential failure. Risk appetite must also consider inherently judgmental factors such as compensation systems and the quality of the control environment.

In other words, estimating acceptable thresholds of risk appetite is more an art than a science. The challenge for senior management, boards and prudential supervisors is to exercise the necessary judgments as to how factors such as incentives, the quality of the control environment, the point in the business cycle and other qualitative inputs will influence the appetite for risk. All large banks must periodically conduct comprehensive exercises aimed at estimating risk appetite. The results of such exercises should be shared with the highest level of management, the board of directors and the institution’s primary supervisor.

Precept IV: Focusing on Contagion
The basic forces that give rise to contagion are reasonably well known and recognized. These include:
· credit concentrations;
· broad-based maturity mismatches;
· excessive leverage
· the illusion of market liquidity.

All large financial institutions must regularly brainstorm to identify “hot spots” and analyze how such “hot spots” might play out in the future. Even if the “hot spots” do not materialize or even if unanticipated “hot spots” do materialize, the insights gained in the brainstorming exercise will be of considerable value in managing future sources of contagion risk.

Precept V: Enhanced Oversight

The board must provide an appropriate degree of oversight of the company consistent with the goal of maximizing shareholder value over time. It is difficult for outside independent directors to fully grasp all the risks associated with the day-today activities of large banks. But they can ask the right questions and insist on necessary information – properly presented so that they can exercise their oversight responsibilities.

The highest-level officials from primary supervisory bodies should meet at least annually with the boards of directors of large integrated financial intermediaries. The supervisory authorities must share with the board and top management their views on the underlying stability of the institution and its capacity to absorb periods of adversity. The spokesperson from the supervisory body should be a true policy level executive or, preferably, a principal of the supervisory body. These high level exchanges of views should minimize the use of quantitative metrics and maximize the use of discussion and informed judgment.

The core precepts mentioned above are interrelated. No one institution can, by itself, accomplish all that needs to be done in restoring the credibility of the industry and limiting future financial stocks. There must be collective and concerted industrywide initiatives supported by progressive and enlightened prudential supervision.

Improving capital adequacy and liquidity

The widelt cited Turner review has proposed seven key measures with respect to capital and adequacy, accounting and liquidity policies.

Increasing the quantity and quality of bank capital.
The required capital ratios for banks should be expressed entirely in terms of high quality capital, i.e., Core Tier 1 and Tier 1 definitions – and should not count dated subordinated debt. The current international rules effectively result in an absolute minimum of 2% Core Tier 1 relative to Weighted Risk Assets (WRAs), 4% Tier 1 and 8% total capital (including dated subordinated debt). The Turner review calls for a future regime in which the minimum Core Tier 1 ratio throughout the cycle is 4% and the Tier 1 ratio 8%. This will ensure the generation of an additional buffer equivalent to 2-3% of Core Tier 1 capital at the top of the cycle. Supervisors can insist on a further discretionary buffer above this.

Significant increases in trading book capital:
The current capital regime, requires only very light levels of capital against trading books. The risks are considered low because of the assumption that assets can be rapidly sold and positions rapidly unwound. Major changes to trading book capital, and a fundamental review of the whole methodology of assessing trading book risk are the need of the hour.

Avoiding procyclicality in Basel 2 implementation.
The way in which capital requirements and the actual level of capital vary through-the-cycle is as important as the absolute minimum level. Counter-cyclicality must be injected into the capital regime.

Creating counter-cyclical capital buffers.
Capital must increase in good years when loan losses are below long run averages, creating buffers which can be drawn down in recession years as losses increase. This would slow down the growth of bank lending in the upswing, and in the downswing reduce the extent to which banks need to cut back on lending.

Offsetting procyclicality in published accounts.
This countercyclical element of capital anticipating future losses should be reflected in published account figures as well as in calculations of required or actual capital.

A gross leverage ratio backstop.
A gross leverage ratio must back risk weighted capital as a control measure.

Containing liquidity risks in individual banks and at the systemic level.
Regulation relating to liquidity risk management should reflect three considerations:
• Liquidity risk has inherently systemic characteristics. The reaction of one bank to a liquidity crisis can cause major liquidity strains for others.
• Liquidity management has become increasingly complex over time, with an increased reliance on ‘liquidity through marketability’. So liquidity regulation cannot be based on one or a few standard ratios comparable to the capital adequacy ratio used to regulate solvency.
• At the macroeconomic and macro-prudential level, there is a tradeoff involved. Increased maturity transformation delivers benefits to the non bank sectors of the economy and produces term structures of interest rates more favourable to long-term investment. But the greater the aggregate degree of maturity transformation, the more the systemic risks.

Why systemic risk went out of control

According to the widely cited Turner review, published by the UK Financial Services Authority, five key features of the global financial system played a crucial role in increasing systemic risk that led to the meldown.

The growth of the financial sector.
The disproportionate growth of financial sector debt, driven by securitisation led to an explosion of claims within the financial system, between banks and investment banks and hedge funds. This growth of the relative size of the financial sector, magnified the potential impact of financial system instability on the real economy.

Increasing leverage
From about 2003 onwards, there were significant increases in the measured on-balance sheet leverage of many commercial and investment banks. At the same time, ‘risk adjusted’ measures of leverage (e.g. Value at Risk (VAR) relative to equity) showed no such rise. This was because capital requirements against trading books, where the asset growth was concentrated, were extremely light compared with those for banking books. VAR measures suggested that risk relative to the gross market value of positions had declined. Clearly, these measures were faulty and the required trading book capital was inadequate.

The build up to the crisis saw the rapid growth of highly leveraged off-balance sheet vehicles – structured investment vehicles (SIVs) and conduit. The classification of these entities as off-balance sheet resulted in a misrepresentation of true economic risk. Liquidity provision commitments and reputational concerns forced many banks to take the assets back on their balance sheets as the crisis grew, resulting in a significant increase in measured leverage. Moreover, products like CDOs, had very high and imperfectly understood embedded leverage. Their vulnerability to shifts in confidence and liquidity was grossly underestimated.

Changing forms of maturity transformation.
One of the key functions of the banking system is maturity transformation. In recent years, much of the aggregate maturity transformation has been occurring not on the banking books of regulated banks, but in other forms of ‘shadow banking - SIVs, conduits, investment banks. And in the US, mutual funds have made implicit or explicit promises not to allow net asset value to fall below the initial investment value. As a result, during a liquidity crisis, mutual funds may sell assets rapidly to meet redemptions. This can contribute to systemic liquidity strains.

Aggregate maturity transformation being performed by the financial system seems to have increased substantially over the last two decades. And many institutions thought it was safe to hold long term assets funded by short-term liabilities on the grounds that the assets could be sold rapidly in liquid markets if needed. This assumption was valid during the benign economic conditions that prevailed before the sub prime crisis, but became rapidly invalid during the crisis, as many firms attempted to liquidate their positions simultaneously.

A misplaced reliance on sophisticated maths.
There was a general belief that that the increased complexity of structured products had been matched by the evolution of mathematically sophisticated and effective techniques for measuring and managing the resulting risks. Top management and boards found it difficult to understand the complex maths and to assess and exercise judgement over the risks being taken. Mathematical sophistication only ended up providing a false assurance that other visible indicators of increasing risk (e.g. rapid credit extension and balance sheet growth) could be safely ignored.

Hard-wired procyclicality.
The marketability of various assets where no historic record existed, depended on credit ratings. These ratings proved misleading predictors of risk. Senior notes of SIVs, for instance, were often awarded high credit ratings on the grounds that if the asset value fell below defined triggers, the SIV would be wound up before senior note holders were at risk. At the system level, however, this resulted in attempted simultaneous asset sales by multiple SIVs. Liquidity rapidly disappeared as market value limits were triggered and ratings were cut. In case of some derivative contracts, the level of collateral depended on the credit ratings of counterparties. Credit default swaps (CDS) and other OTC derivative contracts entered into by AIG, for instance, required it to post more collateral if its own credit rating fell. When this occurred in September 2008, a downward spiral of increased liquidity stress and falling perceived credit worthiness rapidly ensued.

The road ahead for banking regulation

The global financial meltdown has come as a rude shock to regulators. Regulation has clearly failed to keep pace with complexity. Many of the institutions guiding the financial system in the west, especially in the US were fashioned during the Great Depression. In the past seven decades, the financial system has become considerably complicated and interlinked but regulation has not kept pace.
It is clear that multiple regulators in the US aggravated the sub prime meltdown. The Fed, Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the Office of Thrift Supervision (OTS) and the National Credit Union Association (NCVA) were all involved in mortgage regulation. As Mark Zandy of Moody's has mentioned, “… with so many diverse groups involved, it was difficult to get a working quorum for decision making. At a time when oversight was most desperately needed on mortgages, half the nation’s lenders were regulated at the federal level and half by the states… Understaffed state regulators lacked resources to monitor a rapidly growing and increasingly sophisticated mortgage industry.” Jamie Dimon CEO, has echoed similar sentiments in JP Morgan’s 2008 annual report, “Overlapping responsibilities have led to a diffusion of responsibility and an unproductive competition among regulators which probably accelerated a race to the bottom.” Many regulators also lacked the appropriate statutory authority to deal with some of the problems they were about to face during the financial meltdown.

Banks must adopt a more long term approach towards capital management. They must build a buffer during the good times that they can draw down during a recession. A key challenge for regulators is to estimate the amount of capital that can act as a reasonable safety buffer to cope with a downturn. The figure of 8% of risk weighted assets is being challenged. Indeed, many global banks have started to maintain capital amounts much larger that this figure. The quantum of capital should change dynamically with the needs of the system. As Bruner and Carr point out,“The question of adequate sufficiency must be tested relative to the size of the available assets and the size of the shocks the buffer is meant to absorb. Over time, the size and complexity of the economy will outgrow the sophistication of static financial safety buffers.”

Improving the transparency of derivatives trading

On improving the transparency of financial products in general and drivatives in particular, many suggestions have been put forth by academics, regulators and bankers. Calomiris mentions there are two separate issues that need to be addressed by regulators. Banks should be encouraged to move from OTC to central clearing arrangements to deal with the systematic consequences of opacity in counterparty risk. The clearinghouse, would effectively stand in the middle of all transactions as counterparty and thereby eliminate the problem of measuring counterparty risk. Clearinghouses have been quite good at dealing with counterparty risk. But clearinghouses may not be practical for highly customized OTC contracts. A regulatory cost can be imposed on OTC contracts that do not clear through the clearinghouse (in the form of a higher capital or liquidity requirement) to encourage, but not compel, clearinghouse clearing. For contracts where the social benefits of customization are high, banks’ fees will compensate them for the higher regulatory costs of bilateral clearing.

The second issue, Calomiris mentions is the problem of monitoring and controlling the net risk positions of individual banks and the systemic consequences of those positions. Requiring that all derivatives positions be publicly disclosed in a timely manner may not be practical. Disclosure of their derivatives positions could place banks at a strategic disadvantage with respect to others in the market. This might even reduce aggregate market liquidity. For example, if Bank A had to announce that it had just undertaken a large long position in a currency contract, other participants might expect that it would be laying off that risk in the future. This could lead to a decline in the supply of long positions in the market and a marked change in the price that would clear the market. A better approach to enhancing disclosure, therefore, would be to require timely disclosure of positions only to the regulator, and public disclosures of net positions with a lag.

Dealing with asset bubbles

Another big theme in the current debate on changes in the regulatory framework is the need to prevent asset bubbles. While Greenspan & Co seemed to have successfully controlled inflation in the 2000s, they did not pay as much importance to the rising real estate prices. Identifying and preempting asset bubbles can go a long way in preventing shocks to the economy. Since the financial system plays a critical role in the formation of bubbles, appropriate regulation is needed.

Calomiris mentions that prudential regulations can succeed in reducing the supply of credit by tightening capital, liquidity, and provisioning requirements. This is the most direct and promising approach to attacking the problem of a building asset price bubble, assuming that one can be identified. Greenspan used to argue that it was difficult to identify asset bubbles. And the costs associated with tackling “imaginary” asset bubbles would be high. Calomiris accepts that there are economic costs associated with adopting macro prudential triggers to combat asset bubbles. Credit slowdowns and capital raising by banks may happen during periods identified as bubbles that are in fact not bubbles. These costs, however, are likely to be small. If a bank believes that its extraordinary growth is based on fundamentals rather than a bubble, then it can raise capital in support of continuing loan expansion. The cost to banks of raising a bit more capital during expansions is relatively small. Most importantly, macro prudential triggers would promote procyclical equity ratios for banks, which would mitigate the agency and moral-hazard problems that encourage banks to increase leverage during booms. During the subprime boom, commercial banks and investment banks substantially raised their leverage.

Indeed, we can learn from history in this context. There have been occasions in the past when banks behaved more prudently and wisely. During the boom era of the 1920s, New York city bank expanded their lending dramatically. Their loan-to-asset ratios also rose as the banks participated actively in promoting the growth in economic activity and stock prices during the 1920s. But recognizing the rising risk of their assets, the banks made adjustments accordingly and substantially raised their equity capital. New York banks went to the equity market frequently in the 1920s, and on average increased their market ratios of equity to assets from 14 percent in 1920 to 28 percent in 1928. Virtually no New York City banks failed during the Depression.

Dealing with the too big to fail syndrome

One major problem with the banking system today is that many of the institutions are so large that it is difficult to imagine they can be allowed to fail by governments and regulators. That is why the collapse of Lehman was an epochal event in modern finance. Raghuraman Rajan argues that the right way to deal with the “too big to fail” syndrome is not to impose regulations that limit the size and activities of institutions. A better approach is to make it easier to close down these institutions. Systemically important financial institutions must be required to develop a plan that would enable them to be wound down in a matter of days. Such arrangements have been called “living wills”, “assisted euthanasia,” or “shelf bankruptcy” plans by different writers. Banks would need to track, and document, their exposures much more carefully and in a timely manner. The plan would require periodic stress testing by regulators and the support of enabling legislation— such as facilitating an orderly transfer of a troubled institution’s swap books to precommitted partners. The requirement to develop resolution plans would give institutions a strong incentive to reduce unnecessary complexity and improve management. Such an arrangement might also force management to be better prepared to deal with unexpected worst case scenarios.

As Calomiris mentions, living wills can create benefits for the financial system both prior to and during a crisis. Before a crisis, large complex banks would be more careful in managing their affairs. If the institutions are forced to plan their resolutions credibly in advance, and if this planning process is very costly, then they may appropriately decide to be less complex and smaller. After a crisis, because of the element of planning, changes in the control over distressed banks would occur with minimal disruption to other financial firms.

Injecting countercyclicality into Basle 2

The lack of counter cyclicality in the Basle II framework has received considerable attention from many other economists and practitioners in recent months. Indeed, except for the emergency actions of the government, there has been little to offer by way of counter cyclicality during the recent crisis.

Jamie Dimon, CEO of JP Morgan has made three specific suggestions for improving counter cyclicality in the bank’s 2008 annual report.
v Loan loss reserves can be estimated based on the estimation of credit losses over the life of the loan portfolio. Banks can increase reserves when losses are low and run down the reserves when losses are high.
v If a bank lends very aggressively, the central bank can either impose higher capital costs or reduce the amount it lends to the bank.
v The process of raising capital must be accelerated during a downturn. Banks should be able to make a rights issue in days rather than weeks.

A complex financial system combined with a buoyant economy is a dangerous combination. In a booming economy, there is tremendous demand for capital. So financial institutions are prepared to take more risk than is warranted. When an economic shock hits the system, optimism gives way to pessimism, leading to a self reinforcing downward spiral. When an external shock occurs, banks realize they do not have enough capital in relation to the risks they have taken. They reduce lending. This in turn triggers off a liquidity crisis. So buffers must be built during the good times to be drawn down during recessions.

Raghuram Rajan mentions that, faith in draconian regulation is strongest at the bottom of the cycle. But that is the time, when there is little need for market participants to be regulated. At the same time the misconception that markets will take care of themselves is most widespread at the top of the cycle. Incidentally, that is the point when there is maximum danger and a compelling case for tightening regulation.

How can regulators inject counter cyclicality in the system? In boom times, the market demands very low levels of capital from banks as the general euphoria makes losses seem remote. Should regulators impose higher capital requirements on banks? But we know from past experience that when regulated financial intermediaries are forced to hold more costly capital than the market requires, they try to shift activity to unregulated intermediaries. Even if regulations are strengthened to detect and prevent this shift in activity, banks can always find loopholes that get around capital requirements. At the same time, during a downturn, risk-averse banks will hold much more capital than regulators require. No amount of prodding will bring back the credit expansion that is critical for an economy in a serious recession.

In short, it is not so simple to deal with the cyclicality inherent in the current regulatory framework. Rajan argues new regulations should be comprehensive, contingent, and cost effective.

Regulations should be comprehensive so that they are less likely to encourage the drift of activities from heavily regulated to lightly regulated institutions over the boom. Regulations should also be contingent. They must have the maximum impact when the danger to the system is most potent. This will make regulations more cost effective, and less prone to arbitrage or dilution. For example, instead of raising permanent capital, banks can be asked to arrange contingent capital for troubled times. These “contingent capital” arrangements will be contracted in good times. So they will be relatively cheap compared with raising new capital in a crisis and thus easier to enforce. Because the capital infusion occurs in bad times when capital is really needed, it protects the system and the taxpayer at the right time. Post crisis measures like bailouts can be avoided.

Rather than depending on their discretion, banks could be asked to issue debt that would automatically convert to equity when two conditions are met: first, when the system is in crisis, and second, when the bank’s capital ratio falls below a certain value.

Calomiris adds that “Contingent capital certificates” (CCC)—debts that convert to equity when banks suffer sufficient portfolio losses— may be better than straight subordinated debt for this purpose. CCC are likely to work better than subordinated debt as a source of information about risk and a form of market discipline.

Whatever be the method chosen, there is no doubt, as Rajan mentions that the idea of infusing counter cyclicality in the regulatory framework can no longer be postponed. During a crisis, the temptation on the part of regulators will be to over regulate. Once the recovery takes hold, deregulation will begin and add so much economic value that the deregulatory camp will be strongly empowered. Eventually, though, the deregulatory momentum will gather momentum and eliminate regulatory muscle rather than fat. That is, some of the important checks and balances will go away. Instead of swinging wildly between too much and too little regulation, cycle proof regulation might be a better approach.

The shadow banking system and regulatory challenges

A remarkable feature of the global economy in the last two decades has been the rapid growth of the non regulated part of the financial system. As Jamie Dimon, CEO mentioned in JP Morgan’s 2008 Annual Report. The role of banks in the capital markets has changed considerably. And the change is not well understood – in fact it is fraught with misconceptions. Traditional banks now provide only 20% of the total lending in the economy. Right after World War II, that number was almost 60%. The other lending has been provided by what many call the shadow banking system.”
More importantly, the formal and the shadow banking system are too closely interlinked. Indeed, authorities across the world are realizing that the financial system cannot be managed by dividing it into two segments – core banking institutions that need to be tightly regulated and others such as hedge funds, brokers and structured investment vehicles that can be left to operate on their own since they do not use public money. The “core” and the “shadow banking” segments have become far too interconnected. It is estimated that by the summer of 2007, the assets of the six largest US commercial banks were about $6 trillion while the shadow banking system controlled assets worth $4 trillion. The two systems have become so closely intertwined that the collapse of a shadow banking entity can send ripples across the formally regulated banking world.

The shadow banking system is increasingly coming under scrutiny from regulators across the world. Many European politicians are pressing for curbs on offshore tax centers and hedge funds. The ECB president, Jean Claude Trichet mentioned recently that reforms need to be holistic and regulation must be extended to all important markets that pose fundamental risks to financial stability. The latest round of proposals by the US Treasury in May 2009 seem to echo this sentiment.

But we cannot be too sure whether such an approach represents a long lasting and permanent solution. Curbs on the shadow banking system may allow a new “wild west” to form at the periphery. Moreover, the financial system has always been good at finding loopholes in the existing legal and regulatory framework and moving into segments that bypass regulation. Besides, for a well functioning and liquid market, different participants must have different views towards holding and transferring risk. If all entities try to manage risk and liquidity in the same way, the dynamism of the market will be threatened. The current cyclicality bias in the regulatory system may then be further amplified.

Why regulation is important in the banking industry

Banks are fundamentally different from other corporations in other industries. Banks lie at the heart of the economy. A large section of the population keeps their money with them. Many businessmen and small entrepreneurs depend heavily on these institutions for their capital requirements. Banks create and sustain markets for financial instruments and help in channelising savings into productive investments. They also facilitate payment flows among customers. It is difficult to conceive of a modern economy working without banks.

When a bank fails, the impact can be disruptive for the economy. For example during a banking crisis, investors may retreat to safe government securities, due to lack of confidence in the financial system. This may lead to a sharp decline in investment spending. Consumers may also postpone purchases. As a result, recessionary pressures will gather strength. Several percentage points of GDP growth may be lost in the process. This is exactly what happened during the recent financial crisis.

Banks are inherently fragile as they use a small amount of capital and leverage it to build huge asset positions. Banks assume that all depositors will not demand their money back at the same time. From time to time, banking crises have been witnessed as panicky depositors have tried to withdraw money in droves.

Since banks are inherently fragile, most countries have a system of deposit insurance, which protects small investors in the event of a bank failure. This guarantee of a “bailout” for small investors helps in maintaining customer confidence and consequently preventing a run on the bank. But deposit insurance can lead to a moral hazard problem. Banks may end up taking more risk than they can handle. Also, because they are protected by insurance, depositors may have little incentive to monitor banks. This is where a strong regulatory framework comes in. Regulation aims at providing a robust risk management framework for financial institutions and checking whether enough capital has been set aside to deal with various eventualities.

In short, the following are the reasons given to justify the existence of banking regulation:

v A bank’s depositors are too small to monitor the performance of the bank.
v Banks facilitate payment against and settlement of transactions. If payment and settlement systems break down, there will be chaos.
v The failure of a bank can have systemic effects because of interlinkages with other financial institutions. The systemic risk must be managed carefully. Otherwise, there will be a crisis in the financial markets.The collapse of a major financial institution can affect industrial investment in the region. Other banks may not be able to step in with substitute offers as they may not have enough information on the clients