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.
Saturday, 2 January 2010
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 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.”
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.
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.
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.
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.
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