Università Commerciale Luigi Bocconi
CAREFIN Centre for Applied Research in Finance
Working Paper 16/2010
Andrea Sironi The Basel Committee Proposals For Capital Adequacy Reform: A Critical Analysis
The Basel Committee Proposals For Capital Adequacy Reform: A Critical Analysis
by Andrea Sironi
n. 16/10 Milan, July 2010
Copyright Carefin, Università Bocconi
Further research materials can be downloaded at
www.carefin.unibocconi.eu
INDEX
1.
INTRODUCTION
1
2.
WEAKNESSES OF THE CURRENT CAPITAL ADEQUACY FRAMEWORK
2
3.
QUALITY OF THE CAPITAL BASE
4
4.
PROCYCLICALITY
5
5.
A NEW LEVERAGE REQUIREMENT
8
6.
LIQUIDITY RISK
11
7.
SYSTEMIC BANKS
12
8.
REGULATORY ARBITRAGE BETWEEN BANKING BOOK AND TRADING BOOK
13
CONCLUSIONS
15
References
17
9.
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1. INTRODUCTION
The financial crisis which recently hit the international banking industry clearly highlighted a number of weaknesses in the prudential supervisory framework based on risk-weighted capital requirements. Many observers criticized Basel II, holding it partly responsible for the financial turmoil triggered by the US subprime mortgages crisis. While I do not agree with this view, if for no other reason than the timing of the Basel Committee’s New Capital Accord, which became effective in 2008 when the crisis was already well underway.1 However, there is no doubt that the financial crisis revealed come significant deficiencies in the prudential supervisory framework focused on risk-based capital requirements. In response to these issues, the Basel Committee advanced various proposals, first in July 2009 (Basel Committee, 2009a), specifically addressing market risk capital requirements related to the trading book, and then in December of the same year addressing capital adequacy and liquidity risk supervision (Basel Committee, 2009b and 2009c). These proposals - the building blocks of the framework already widely known as Basel III - are currently being debated in the banking and international financial services industry. The new system will most likely be grandfathered in over a number of years, although the exact timeframe has not yet been established.2 After briefly outlining the main weaknesses of the current capital adequacy framework, and summarizing the Basel Committee’s recent proposals, this paper is aimed at:
reviewing the contents of the proposals, drawing on the results of theoretical and empirical research wherever possible, in order to underscore relative strengths and/or weaknesses;
providing a critical analysis of the strengths and weaknesses of the proposals, which again will take effect after a period of grandfathering and therefore allow researchers and practitioners to evaluate their effectiveness in solving the problems that emerged during the crisis, and to assess their potential consequences.
While the Basel Committee proposals may seem to address some limited technical features of prudential banking supervision, they will most likely have a major impact on the future of the international banking industry as they affect the relative profitability of different banking activities and, more generally, banks’ business models. Indeed, the proposals significantly modify the capital requirements relating to trading, the quantity and quality of regulatory capital, liquidity management, and leverage. In doing so, these measures will inevitably shape banks’ future business strategies, the attractiveness of various business areas, and the relative competitiveness of banks in different countries. This paper is structured as follows. Next section briefly outlines the main problems pertaining to the current prudential supervisory framework highlighted by the recent financial turmoil. The following sections analyze each one of the key Basel Committee proposals: capital quality
1 Cannata-Quagliariello, 2009, make a clear, convincing case in support of the Basel II framework. 2 The Committee has officially pledged to publish a definitive version of its proposals by year end 2010, with the aim of implementation by year end 2012.
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(section 3), procyclicality (section 4), the leverage requirement (section 5), liquidity requirements (section 6), systemic banks (section 7), and trading book capital requirements (section 8). section 9 finally offers an overall assessment of the proposals, focusing on a few issues which appear relevant for regulators, and implications for bank management.
2. WEAKNESSES OF THE CURRENT CAPITAL ADEQUACY FRAMEWORK
As mentioned above, the recent international financial crisis highlighted certain weaknesses in the current capital adequacy framework. The Basel Committee explicitly acknowledges these deficiencies, effectively summarizing them in a single sentence (underlining added):“One of the main reasons the economic and financial crisis became so severe was that the banking sectors of many countries had built up excessive on- and off-balance sheet leverage. This was accompanied by a gradual erosion of the level and quality of the capital base. At the same time, many banks were holding insufficient liquidity buffers. The banking system therefore was not able to absorb the resulting systemic trading and credit losses nor could it cope with the reintermediation of large off-balance sheet exposures that had built up in the shadow banking system. The crisis was further amplified by a procyclical deleveraging process and by the interconnectedness of systemic institutions through an array of complex transactions.”3 Summing up, these weaknesses can be briefly classified as follows:
Level and quality of capital. Several banks that suffered major losses and/or received government bailouts showed capital ratios far above the minimum set by Basel. For example, the base capital ratio (Tier 1) of the major European banking groups averaged 8% in late 2006, just before the crisis hit. This figure is well above the regulatory minimum of 4%. Furthermore, most hybrid and innovative instruments, calculated as regulatory capital, proved ineffective in absorbing banks’ losses (Coletti, 2009).
Procyclicality. An often cited weakness of the Basel II framework, according to the Financial Stability Board and by the Committee’s own admission, is the tendency to exacerbate fluctuations in the economic cycle. This is due to the fact that rating-based capital requirements are prone to rise during recessions (and likewise fall during economic upswings). Banks under stress on their capital ratios are forced to react by limiting their loan supply, or even reducing their assets. This, in turn, magnifies the negative phase of the cycle.
Leverage. Several large international banks were highly leveraged, even though their capital ratios were well aligned with regulatory levels. This phenomenon, along with pro cyclicality, played an incisive role in the recent crisis. In fact, numerous financial institutions sold off sizeable portions of their assets, prompted by the need to enhance their capital ratios. This triggered a deleveraging process which, while guaranteeing solvency for individual banks,
3 Basel Committee, 2009b.
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actually exacerbated the instability of financial markets. What emerged is the need to combine appropriate policies for macro-prudential supervision with traditional microprudential supervision. The former serves to prevent systemic crises, and the latter to safeguard the solvency of single banks (Brunnermeier, et al. 2009).
Liquidity. A major issue facing banks during the financial crisis was the one related to liquidity shortages. Several large banks, used to rely on the huge liquidity of the interbank market, survived solely because of the plentiful supply of cheap liquidity offered by central banks.
Systemic Institutions. During the crisis, a number of banks received government support and were bailed out, spurred by the fear that their collapse would trigger a system-wide crisis. These institutions were – and are still today – considered “systemic banks” due to their deep interconnection with similar institutions through the interbank market or the OTC derivatives market.
Arbitrage between banking and trading book. During the crisis, countless banks suffered major losses on their trading books, mainly on debt instruments. By locating these positions in trading books rather than banking books, banks could take advantage of lower capital requirements.
As already mentioned above, in 2009 the Basel Committee responded to these issues by recommending certain notable changes in the capital adequacy framework and in the rules of prudential supervision in general. The remainder of this paper will explore each of the points mentioned above, recapping the contents of the Basel Committee’s proposals, along with the problems and potential consequences of the proposals.
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3. QUALITY OF THE CAPITAL BASE
The current capital adequacy framework gives banks generous leeway for including hybrid and innovative instruments in the regulatory capital calculation. However, these claims are not as effective as loss absorbers as more traditional forms of capital such as common equity and retained earnings. Moreover, new empirical research (Acharya, Gujral and Shin, 2009; Coletti, 2009) showed that in recent years many banks increased their capital ratios mostly by issuing hybrid instruments, and only marginally by increasing the actual equity component (Core Tier 1). As Gujral and Shin (2009) observed: “Even as banks and financial intermediaries have suffered large credit losses in the financial crisis of 2007-09, they have raised substantial amounts of new capital. However, the composition of bank capital has shifted from [...] common equity to [...] debt-like hybrid claims such as preferred equity and subordinated debt. The erosion of common equity has been exacerbated by large scale payments of dividends.” There are various reasons why banks have resorted more often to hybrid capital instruments: (i) to avoid diluting control, an inevitable consequence of issuing new shares; (ii) to take advantage of tax breaks, given that fiscal authorities normally consider these instruments as debt, which in turn means that the related costs are tax deductible; (iii) some of these instruments offer a particularly appealing risk/return profile for certain types of institutional investors, who would not be willing to invest in banks’ traditional common equity. Despite these advantages, there are certain drawbacks inherent to hybrid instruments which the recent crisis has clearly revealed. Although considered capital by regulators, investors have always viewed hybrids as debt that would be treated as such by issuers (i.e. banks). In other words, conventional market wisdom holds that issuing banks would be sure to pay interest and/or capital on hybrids, even in times of crisis. As recent empirical studies (Coletti, 2009) show, the behaviour of banks corroborates this belief. In fact, to avoid negative fallout in terms of reputation or the future ability to raise capital, very rarely has any issuing bank applied the cancellation clauses embedded in these instruments. This resulted in their poor ability to absorb losses. In response to these issues, the Basel Committee has recommended a significant increase of the weight of the common equity component (core tier 1) in banks’ regulatory capital, although a specific level has not been set yet. In addition, the Committee proposes to simplify the definitions of tier 1 capital and tier 2, and to focus the attention primarily on the relative ability of each capital component to absorb losses “on a going-concern basis”. Last, a number of proposals for specific changes are all aimed at strengthening the common equity component: (i)
the characteristics of instruments eligible for different classes of capital will be more clearly delineated, with the aim of eliminating non-perpetual securities from (upper) tier 1, along with call options and step up mechanisms;
(ii)
separate minimum ratios will be introduced for the common equity component of tier 1 and tier 2;
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(iii)
regulatory adjustments will only be applied only to tier 1 capital (e.g. deductions linked to investments in other financial entities, and goodwill);
(iv)
how regulators deal with different kinds of hybrid and innovative instruments will be further harmonized on an international level.
While all these measures appear reasonable and effective in strengthening individual banks’ solvency, we cannot ignore the potential fallout on banks’ earnings which would inevitably result from raising the minimum core capital requirement. There is a risk that banks will react to higher capital requirements by increasing credit spreads applied to their loans or by shrinking available credit.
4. PROCYCLICALITY
The New Capital Accord, or Basel II, has often been criticized as being procyclical; in other words, it exarcebates the economic cycle’s fluctuations. In fact, during economic downturns, both internal and external ratings tend to deteriorate, probabilities of default rise, and as a result banks are subject to stricter capital requirements. This happens just when capital becomes more expensive, or simply unavailable to weaker institutions. Normally banks react by curtailing lending, which in turn magnifies the recession. As the Financial Stability Board recently commented (2009): “The present crisis has demonstrated the disruptive effects of procyclicality – mutually reinforcing interactions between the financial and real sectors of the economy that tend to amplify business cycle fluctuations and cause or exacerbate financial instability.” Asking banks more capital during a recession is a positive feature of a sound microprudential supervisory policy, which in fact requires individual financial institutions to hold more capital in the face of higher risks. Yet the same rationale is counterproductive when we broaden our perspective from individual banks to the financial system as a whole. If all banks put a squeeze on credit, and in doing so exacerbate the recession, the risk of default climbs and they all end up in even more dire straits. In other words, a good move on the micro-prudential front is not necessarily so in terms of macro-prudential supervision. The Basel Committee actually dealt with this problem in previous years by adopting a series of provisions aimed, among other things, at alleviating the procyclicality of capital requirements: (i) by reducing the steepness of the risk weight curve reflecting counterparties’ probability of default (PD); (ii) by making the time horizon for estimating PD more forward-looking; (iii) by explicitly establishing provisions for stress tests and supplemental capital (buffers) in Pillar II. Current Basel Committee proposals take a three-pronged approach to the procyclicality issue.
First, the Committee recommends a countercyclical capital buffer anchored to credit growth. This essentially consists of a capital requirement that rises during economic growth, when the
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credit supply increases, and falls during recessions. The Committee has presented the details of this proposal in July 20104. The primary aim of this proposal is to use a buffer of capital to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth that have often been associated with the build up of systemwide risk.
Second, the Committee provides regulators with more tools for promoting capital conservation and the consequent build up of capital reserves during positive phases of the economic cycle, resources that can be used during negative phases. These measures should prevent banks from adopting practices such as distributing dividends, buying own shares, or paying big bonuses to executives during recessions.
Third, the Committee supports a countercyclical provisioning policy which enables banks to gauge their reserves based on expected loss rather than incurred loss, as is the current practice.
This last point is a particularly relevant one. Clearly, expected losses on a bank’s loan portfolio are closely linked to growth phases in loans, since new loans will bring in some expected loss even though they are fully performing initially. If banks were to build up their reserves during upswings in the economic cycle, they could then use part of these resources during economic downturns. This would generate countercyclical behaviour for reserves, which would effectively offset the pro-cyclical dynamics of capital requirements. A recent CAREFIN study (Iannotta, Resti et al., CAREFIN 2009) explored the Spanish experience of “dynamic (statistical) provisioning.” This approach explicitly calls on banks to grow their reserves when their loan portfolios grow. Results showed a positive correlation between provisioning and GDP growth, in other words, countercyclical behaviour of credit reserves. The open issue here is how to reconcile two different perspectives: the “accounting framework”, based on the principle of objectivity, i.e. provisions can only go through the income statement when losses actually occur; and the “prudential framework”, following the riskmanagement rationale linking reserves to expected loss. One possible solution to this cultural conflict was recently proposed by the Financial Stability Board (2009), which sees the incurred loss approach as a way to obtain reserves that are more flexible and consistent with the concept of expected loss. In the words of the Financial Stability Board (2009): “The incurred loss approach allows for considerable use of management’s expert credit judgment to ensure that loan loss provisions reflect the credit losses inherent in loan portfolios. … The FASB and IASB should reconsider the incurred loss model by analysing alternative approaches for recognising and measuring loan losses that incorporate a broader range of available credit information.” In keeping with this idea, one solution could be a revision of IAS 39, as proposed by the IASB and supported by the Basel Committee. This would entail factoring in expected loss (and not only incurred loss) by adjusting the discount rate. Coupled with the revised provisioning system, procyclicality could be effectively offset by using instruments commonly referred to as contingent capital, originally proposed by Mark
4 Basel Committee on Banking Supervision, Consultative Document, “Countercyclical capital buffer proposal”, July 2010.
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Flannery in 2002 (Flannery, 2002) and more recently taken up by various economists (Flannery, 2009; Kashyap et al., 2008; Zingales and Hart, 2009). This mechanism calls for large banks, which benefit the most from implicit government protection in times of crisis, to issue contingent capital certificates which must automatically converted from debt to equity when the equity ratio of the issuing bank falls below a set threshold. Interesting to note, recently a few large international institutions have issued similar instruments, albeit with automatic conversion mechanisms based on the book value of the bank’s assets. In my opinion, one of the lessons learned from the recent turmoil is that linking banks’ portfolios to markets would be a much more effective way to safeguard solvency, especially because there is usually considerable lag time before a collapse in market values gets transmitted to book values.
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5. A NEW LEVERAGE REQUIREMENT
Related to the issue of procyclicality is leverage. Empirical evidence confirms that a number of big international banks have appreciably grown their leverage (measured as a simple ratio of total assets to equity capital) without reducing their total risk-weighted capital ratio. Figure 1, showing a sample of 153 large international banks, maps the total capital ratio on the y-axis and leverage on the x-axis, measured as a simple ratio of total assets to equity. As the graph illustrates, even banks with relatively similar capital ratios vary widely in terms of leverage. In fact although the average leverage is 24, several banks are over 50.
Figure 1
Capital ratio and leverage in a sample of large international banks 2008
30
Tot Capital Ratio (%)
25 20 15 10 5 0 0
10
20
30
40
50
60
70
80
Leverage (TA/E)
Figure 2 maps the averages of the same data for major countries. Interesting to note here is that Italian banks, despite having a lower average capital ratio than large banks in other countries, actually show lower leverage overall.
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Figure 2
Avg capital ratio and leverage by country ‐ 2008 16
15
Capital Ratio (%)
14
13
12
11
10 2
7
12
17
22
27
32
37
42
47
Leverage (TA/E)
In responding to this situation, in April 2009 the Financial Stability Board recommended integrating the capital adequacy framework centred on the capital ratio with a leverage requirement based on a simple total assets/equity ratio: “The Basel Committee should supplement the risk-based capital requirement with a simple, non-risk based measure to help contain the build-up of leverage in the banking system and put a floor under the Basel II framework.” The Basel Committee espoused this recommendation, and incorporated a maximum leverage threshold in its December 2009 proposal. This standard, yet to be quantified, would be a minimum ratio of high quality capital (Core Tier 1) and total assets, the latter including offbalance sheet exposures. In my opinion, the introduction of a leverage requirement runs counter to the evolution underway for the past twenty years in the capital adequacy framework created by Basel I in the late ‘80s. Throughout this period, risk weighting for various classes of credit exposures has gradually been fine-tuned based on the findings of theoretical and empirical research. Literature has clearly and repeatedly underscored how setting a simple capital requirement (expressed as a maximum capital-to-assets ratio) is ineffective in mitigating a bank’s insolvency risk (Kim and Sontomero, 1988). Instead, different risk-weights are needed for different asset classes. Case in point: there is no clear logic behind requiring the same amount of capital to back a high quality government security as for a loan to a high-risk business.
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The Basel Committee is aware of this problem, but justifies this proposal by linking it to two different objectives, beyond simply bounding asset risk: (i) to control the build-up of leverage, thereby mitigating the risks associated with deleveraging processes like those generated during the recent financial crisis; (ii) to contain model risk, and more generally measurement errors linked to the risk weighting method embedded in the current capital adequacy framework; in this regard, the Committee believes that the framework would be strengthened by a simple, transparent risk measure based on gross exposures. Neither of these justifications, in my opinion, can be fully substantiated. On one hand, empirical evidence on the recent deleveraging process does not seem to find a negative correlation between pre-crisis leverage and a decrease in total assets. In other words, it does not appear that the banks which sold off a greater portion of their assets had higher leveraging before this process began. Research results on market trends also show that the banks hit the hardest by the market crash were not the ones with the highest leveraging (Beltratti-Stulz,2009). On the other hand, I do not agree with the argument that a model risk restriction and a simple transparent requirement can compensate for possible errors or inaccuracies in risk weighting. There are two main reasons why. First, a capital requirement expressed as a minimum capital-tototal-assets ratio does not obviate the problem of a risk-based measure; such a metric simply attributes an equal weight of 100% to all asset classes. For this reason, it is hard to believe that possible errors in the weighting system can be corrected by assigning all exposures the same weight, a weight which is, in some respects, incorrect. Second, calculating a leverage requirement necessitates specifying the total exposures that constitute the denominator (total assets). This means we have to take duly weighted off-balance sheet exposures into account as well. Once again, this can not easily be considered truly simple or transparent. Summing up, the basic doubts surrounding this innovative proposal justify further analysis to better explore the relationship between a bank’s leveraging and its risk, and between leveraging and the chances of future deleveraging.
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6. LIQUIDITY RISK
As Anolli and Resti (2009) observed, in recent years a variety of factors have driven banks’ liquidity risk upward. The globalization of major financial groups means that they hold assets and liabilities in myriad counterparties, also through subsidiaries in developing countries. As a result, it is more complicated to keep a complete, updated picture of all possible future cash flows. Technology has made bank transfers faster, not only for professional counterparties but for retail customers as well (thanks to internet banking). Securitisation, on one hand, has enabled banks to transform assets (such as mortgages and instalment loans) which would be hard to negotiate on a secondary market. On the other, however, originating banks often have to commit to supplying liquidity lines on demand. More and more investors such as hedge funds utilize leverage to implement arbitrage strategies, and quickly shift large volumes of funds between markets. This heightens the risk of liquidity crises on the financial markets, in particular less developed, more peripheral ones. The concentration of major financial groups has led to the creation of a small pool of institutions that divvy up most of the market. This means that if these giant banks default, or even momentarily withdraw from trading, the repercussions on the entire financial system would be profound. Until the recent crisis hit, banks did not respond to this growing risk by allocating more human resources and technology for risk management. In part, the reason why may be found in the huge liquidity of the interbank market, which any adequately capitalized bank could access to deal with potential liquidity shortages and to manage liquidity in general. The financial crisis, instead, has dramatically demonstrated that a collapse in confidence and a corresponding surge in counterparty risk can cause a liquidity squeeze on the markets, triggering unexpected acute stress scenarios for individual institutions. The Basel Committee has responded to this situation by proposing two new minimum liquidity ratios.
First, the liquidity coverage ratio is designed to ensure that banks maintain an adequate level of high quality liquid assets which can be readily converted into cash to withstand an acute short-term stress scenario. The ratio of high quality liquid assets to net cash outflows projected for a 30-day time horizon under stress must be greater than 1.
Second, the net stable funding ratio aims to encourage banks to balance stable (medium to long term) funding sources with their corresponding medium to long term needs, precisely by mandating that the ratio of available stable funding to required stable funding always be greater than one.
The Committee also supports the implementation of a number of monitoring tools for tracking banks’ liquidity levels, to be adopted by national supervisors. Most likely, these new requirements will effectively guarantee that banks maintain adequate liquidity, enabling them to ride out future crisis scenarios should they recur. But the question is how much this greater security will cost. Both requirements significantly impact how banks are run, specifically as far as their ability to transform maturities. As such, these standards will reshape banks’ business models and their profitability in general. For these reasons, both requirements call for further analysis of potential consequences on banks’ balance sheets.
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7. SYSTEMIC BANKS
A problem that clearly emerged during the recent financial turmoil is the high degree of interconnectedness, or “entangledness” of certain large financial institutions. This opened the way for shocks to reverberate from one bank to the next, a phenomenon which was one of the key motivators behind numerous government bailouts. As the Economist writes in March 2008 with regard to the Bear Stearns case: “Bear is a counterparty to some $10 trillion of over-thecounter swaps. With the broker’s collapse, the fear that these and other contracts would no longer be honoured would have infected the world’s derivatives markets. Imagine those doubts raging in all the securities Bear traded and from there spreading across the financial system; then imagine what would happen to the economy in the financial nuclear winter that would follow. Bear Stearns may not have been too big to fail, but it was too entangled.” From a broader perspective, as the Basel Committee acknowledged, while procyclicality amplified shocks over time, the tight interconnectedness of certain large banks and other financial institutions allowed shocks to travel through space, via the financial system and the economy. The blame for this problem lies with banks with a systemic risk profile, the so-called systemic banks. Because of their size and their degree of interconnectedness with the rest of the financial system, if one of them defaults, a system-wide crisis would inevitably ensue. In light of this, the Basel Committee is engaged in developing metrics to help national regulators quantify the level of systemic relevance of individual banks, and to identify policies and tools that minimize the probability and the impact of crisis scenarios among systemic institutions. Also under consideration by the Committee are additional capital and liquidity charges for systemic banks; holding these institutions to higher standards could be economically justified by the fact that their cost of uninsured liabilities is lower thanks to the conjectural guarantees - associated to the government safety net – enjoyed by them. Following this line of reasoning, accurately identifying the degree of systemic risk of a financial institution becomes the challenge. Specifically, what makes a bank systemically important? We could argue that the only relevant variable is size, as reflected by total assets, seeing as every other significant characteristic is actually closely correlated to size. So, any bank above a certain size would be defined as systemic. However, other factors could play a role in determining a bank’s systemic risk profile. Examples may be total interbank liabilities, the number and amount of OTC derivatives with negative mark to market, the bank’s role in global custody or underwriting, and its involvement in the primary capital markets. To find a solution to this problem, the first thing to consider is that systemic risk in the financial system is generated by two factors. First, economic performance for all banks is based on the same dynamics: the evolution of the economic cycle, interest rate fluctuations, trends in default rates, and so on. This means that all financial institutions are in some way dependent to some key common systemic risk factors. The second factor involves the risk of contagion, that is, the fact that banks are interconnected by creditor/debtor positions in such a way that a crisis in one bank can spread to others. International research on systemic risk in the financial system has made noteworthy advances in recent years, particularly in measuring this type of risk. Several theoretical and empirical
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studies have offered alternatives for measuring both systemic risk and how much an individual institution contributes to that risk.5 Empirical estimates made by various authors show significant variations in systemic risk in the financial system over time. Furthermore, this risk is strongly impacted not only by the common dependency on shared risk factors relating to returns on bank assets, but also by the contagion effect, the microeconomic causes of which are not yet entirely clear. Although size still appears to be the single best explanatory factor for a financial institution’s contribution to systemic risk, it is by no means the only relevant one. Recent empirical studies (Adrian and Brunnermeier, 2009) show that banks with a larger maturity mismatch, bigger size, and a higher market to book ratio also account for a greater share of systemic risk. In light of this, systemic risk and the contribution individual financial institutions to this risk are definitely compelling problems. As such, they call for further analysis by regulators and researchers to find appropriate solutions.
8. REGULATORY ARBITRAGE BETWEEN BANKING BOOK AND TRADING BOOK
An additional issue which came to light during the recent crisis involved massive losses incurred by a number of banks on their trading books. Often far above the 10-day VaR at 99% confidence levels underpinning market risk capital requirements for banks using validated internal models, these losses were mainly caused by market price volatility on credit-related positions, such as those resulting from securitisation transactions. Price changes in turn were triggered by the liquidity crash, default events, or credit migrations (deterioration of credit worthiness). This phenomenon revealed at least three problems:
First, market risk models used by banks failed to capture the potential effects of liquidity crisis scenarios.
Second, credit-related positions were included in the trading book, where the main focus is market risk, despite the fact that the primary risk for these instruments is actually borrowers default (typically on securitised credit portfolios).
Third, closely related to the previous point, many banks with validated internal models practiced regulatory arbitrage, artificially moving credit positions from the banking book to the trading book to take advantage of the lower capital charge applied to the latter.
5 See Huang, Zhou and Zhu (2009a and 2009b), Adrian and Brunnermeier (2008), Tarashev, Borio and Tsatsaronis (2009a and 2009b).
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To address these issues, in July 2009 the Basel Committee recommended a number of important changes in the capital adequacy framework associated with market risk. Specifically, two additional requirements are to be implemented: (i) Incremental Risk Charge (IRC) relates specifically to risk on trading book positions, to be applied to banks that use validated internal models approach, based on a one-year time horizon and a 99.9% confidence level, which should be measured to adequately reflect the liquidity horizons of the individual positions. (ii) Stressed VaR relates to losses associated with periods of acute stress. As with capital requirements applied to banks with validated models, the Stressed VaR calculation is based on a 10-day VaR with a 99% confidence level relating to historical data from a year with significant losses (subject to supervisory approval). Dual objectives underpin these two additional requirements: to overcome the inducement for regulatory arbitrage between the banking book and trading book, and to set down a capital requirement for market risk which adequately reflects the liquidity risk of trading positions (especially those with credit risk profiles). The importance of this last point became evident during the recent financial crisis. As far as Stressed VaR, an additional aim relates to the problem of procyclicality: clearly if a capital requirement is measured during acute stress, it tends to remain stable (not to decrease) in times of growth and low market volatility. Evaluating the adequacy of these new requirements is no easy task. There is no doubt that they will generate much stricter capital requirements for market risk, in particular for banks using validated internal models. Moreover, it is no doubt appropriate to strengthen requirements which will discourage regulatory arbitrage and better capture the impact of liquidity crises. However, in my opinion, there are insufficient grounds to support the increase that the new proposals would entail (an increase justified by general scepticism regarding the risk measurement models used by banks). During the recent crisis, VaR models were widely criticized, specifically for their reliance on too short time series and gaussian probability distributions or similar that failed to capture the extreme scenarios that arose. However, often critics neglected to ascertain empirically the actual performance of VaR models used by banks during the crisis. As Finger (2009) recently pointed out, “While it is true that the normal distribution is an oversimplification of empirical loss experience, the continued burning in effigy of Karl Friedrich Gauss has distracted the dialogue from numerous other points.” An example is an interesting survey (Campbell, 2009) of the results of VaR model backtesting run by certain large international banks with validated internal models. This survey reports that the banks with fewer exceptions (best performance) used a model based on shorter a time series, for example, Bank of America. Conversely, banks which applied a longer times series, such as UBS, showed much worse performance than the model predicted. More generally speaking, before blaming VaR models for banks’ substantial trading book losses, we should answer two questions. How much of the blame lies with these models for failing to flag the sudden spike in risk? And how much blame lies instead with management? After all, relying on these models, quite often management simply interpreted the surge in risk metrics as temporary, contingent, and not to be taken too seriously in formulating future policies for managing positions.
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9. CONCLUSIONS
In analyzing the Basel Committee’s proposals, one can conclude that the reform of the capital adequacy framework rightly focuses on the main weaknesses brought to light during the recent financial crisis. Although the Committee has yet to provide all the details of these proposals, there is nearly unanimous consensus as to their effectiveness in tackling these problems. However, certain issues not covered in this paper warrant further attention, particularly with regard to four points:
Market discipline. Appropriately, this represented a fundamental pillar of the Basel II framework, in other words, reinforcing the disciplinary role of the market. In fact, due to more exhaustive disclosure rules, the market can distinguish between more or less risky banks, charging the riskier ones more for funding, and in doing so prompting these banks to reduce risk. But market discipline may turn out to be a critical casualty of the financial crisis: countless government bailouts over the last few years have undeniably undermined this pillar. In fact, whatever disciplinary pressure investors might exert on these banks is weakened by the awareness that big banks enjoy implicit protection. The Basel Committee should take a strong unequivocal stand on this issue, which may also serve as a guideline for future government intervention. If supervisors are still intent on pursuing this goal, governments should divest in bank capital as quickly as possible, and clearly establish the level of protection that they will afford to various holders of bank liabilities in the future.
Levelling the playing field. The capital adequacy framework designed by the Basel Committee has from the outset aimed to develop a standardized regulatory system which does not give banks from one country an advantage over any others; in other words, the intention was to create a level playing field. In keeping with this, the Committee proposals briefly outlined here consist of standardized regulations for banks in all countries. However, significantly shoring up capital requirements will have a greater impact on banks that are currently less capitalized. From this standpoint, we can not ignore the fact that in recent years the governments of the major economically developed countries have provided very different levels of support for their respective banking industries (as new research confirms, Bongini et al., 2009), such support also being contingent on the state of public finances of each individual country. As a result, at the starting line of this important reform process, not all banks are equally “fit”. This is why the grandfathering period must be long enough to allow banks in different countries to gradually come up to speed on the new regulatory track.
Business mix, liability structure and risk level of banks. The capital adequacy framework introduced in the late ‘80s by the Basel Committee, and later modified with Basel II, is based on the assumption that the minimum amount of capital that a bank must hold is contingent on the risk embedded in its assets. With the exception of the requirement linked to operating risk, in fact, the entire risk-weighting system centres on a bank’s assets. However, new empirical studies on the recent financial crisis showed that banks hit the hardest were the ones which held a mix of revenues least affected by interest margins. In other words, these institutions had a business mix furthest removed from traditional banking activities (e.g. Bongini, Ferri, Lacitignola, 2009; Beltratti and Stulz, 2009). This raises certain questions: Should a bank’s capital requirement also reflect the degree of risk associated with that bank’s
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business mix (i.e. the typical breakdown of revenues from the last few years)? Likewise, should the liability structure of a bank also be taken into account when fixing the minimum capital requirement? These are particularly important questions, especially considering that instruments such as covered bonds are becoming more common, which “subtract assets from the service of account holders,” as Mottura (2009) comments in an insightful reconstruction of the Northern Rock case.
The new requirements and the cost of credit to the economy. The final issue has already been mentioned, but calls for careful consideration and proper quantitative assessments. It involves the impact of the new capital and liquidity requirements on the profitability of the banking industry and - consequently - on the cost of credit for the entire economic system. We can not doubt the effectiveness of the new proposals as far as providing greater protection for banks’ liquidity and solvency, and consequently stabilizing the financial system as a whole. By the same token, we can not deny the fact that the new measures represent major costs for bank management, costs which will unavoidably take the form of a wider spread that banks apply to corporate loans. The magnitude of this inevitable outcome should be properly assessed by means of a cost/benefit analysis of the proposals which are currently being debated by regulators and by the international banking industry.
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References
ACHARYA V. V., GUJRAL I., SHIN H. S. , Dividends and Bank Capital in the Financial Crisis of 20072009 (March 18, 2009). Available at SSRN: http://ssrn.com/abstract=1362299. ADRIAN T., BRUNNERMEIER M. K., 2009, “CoVaR”, FRB of New York Staff Report No. 348. ANOLLI, M. E A. RESTI, 2009, “An Introduction to Liquidity Risk”, in Pillar II in the New Basel Accord: The Challenge of Economic Capital, edited by A. Resti, Riskbooks. BASEL COMMITTEE, 2009A, Revisions to the Basel II market risk framework, Consultative document, July. BASEL COMMITTEE, 2009B, Strengthening the resilience of the banking sector, Consultative document, December. BASEL COMMITTEE, 2009C, International framework for liquidity risk measurement, standards and monitoring, Consultative document, December. BASEL COMMITTEE, 2010, Countercyclical capital buffer proposal, Consultative document, July. BELTRATTI, A. E R. M. STULZ, 2009, “Why Did Some Banks Perform Better During the Credit Crisis? A Cross-Country Study of the Impact of Governance and Regulation”, mimeo. BONGINI, P., M.L. DI BATTISTA, E L. NIERI, 2009, “Crisi finanziaria, interventi statali di ricapitalizzazione e modelli di intermediazione: quale relazione nelle banche europee?”, 14 esimo Rapporto Fondazione Rosselli. BONGINI, P., G. FERRI, P. LACITIGNOLA, 2009, “Was there a ‘small bank’ anomaly in the subprime crisis?”, 14 esimo Rapporto Fondazione Rosselli. BRUNNERMEIER, MARKUS, ANDREW CROCKETT, CHARLES GOODHART, AVINASJ PERSAUD, AND HYUN SHIN, 2009, “The fundamental principles of financial regulation”, Geneva Reports on the World Economy. CAMPBELL, 2009, “The Risk in Value at Risk, Risk, April. CANNATA, FRANCESCO AND MARIO QUAGLIARIELLO, 2009, “The role of Basel II in the subprime financial crisis: guilty or not guilty?”, Banca d’Italia, mimeo. COLETTI, ELENA, 2009, “Il nodo dell’adeguatezza patrimoniale e peculiarità delle banche italiane”, 14 esimo Rapporto Fondazione Rosselli. FINANCIAL STABILITY BOARD, 2009, “Report of the Financial Stability Forum on Addressing Procyclicality in the Financial System”, April. FINGER, CHRIS, 2009, “VaR Is From Mars, Capital Is From Venus”, RiskMetrics Group, Research monthly, April. FLANNERY, MARK J. (2002), “’No Pain, No Gain’ Effecting Market Discipline via ‘Reverse Convertible Debentures’” working paper subsequently published in Hal S. Scott (ed.), Capital Adequacy Beyond Basel: Banking, Securities, and Insurance (Oxford: Oxford University Press, 2005). FLANNERY, MARK, 2009, “Stabilizing Large Financial Institutions with Contingent Capital Certificates,” mimeo. HUANG X., HAO ZHOU AND HAIBIN ZHU, 2009, “A framework for assessing the systemic risk of major financial institutions”, Journal of Banking and Finance, forthcoming. HUANG X., HAO ZHOU AND HAIBIN ZHU, 2009, Assessing the Systemic Risk of a Heterogeneous Portfolio of Banks during the Recent Financial Crisis”, mimeo. IANNOTTA, G., LAGNESE, E. MARIANI, NOBILI, A. RESTI, ZAFFO, 2009, “Banks’ Loan Loss Provisioning: Procyclical Behaviour and Potential Solutions”, Carefin, working paper, 4/11. KASHYAP, ANIL, RAGHU RAJAN AND JEREMY STEIN, 2008, “Rethinking Capital Regulation”, prepared for Fed. Res. Bank Kansas City symposium on “Maintaining Stability in a Changing Financial System”, available at http://faculty.chicagobooth.edu/anil.kashyap/research/rethinking_capital_regulation_sep15.pdf KASHYAP, A. N. AND J. STEIN, “Cyclical implications of Basel II capital standards”, Economic Perspectives, Federal Reserve Bank of Chicago, Vol. 28, 2004, pp. 18-31. KIM, D., A.M., SANTOMERO, 1988, “Risk in Banking and Capital Regulation”, The Journal of Finance, Vol. 43, No. 5 (Dec., 1988), pp. 1219-1233. MOTTURA, PAOLO, 2009, “Quello strano caso di Northern Rock”, mimeo.
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TARASHEV, NIKOLA, CLAUDIO BORIO AND KOSTAS TSATSARONIS, 2009a, “Allocating systemic risk to individual institutions: methodology and policy applications, working paper. TARASHEV, NIKOLA, CLAUDIO BORIO AND KOSTAS TSATSARONIS, 2009b, “The systemic importance of financial institutions”, BIS Quarterly Review. The Economist, 2008, “Wall Street Crisis”, March 18. ZINGALES, LUIGI AND OLIVER HART, 2009, "A New Capital Regulation for Large Financial Institutions", May.
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WORKING PAPERS IN THE CAREFIN SERIES 1/08
2/08
3/08 4/08
5/08 6/08 7/08
8/08 9/08 10/08
11/08 12/08 13/08 14/08
15/08 1/09 2/09 3/09 4/09 5/09 6/09 7/09 8/09
La stima del capitale economico a fronte del portafoglio crediti: un’introduzione alle nuove metodologie Imperfect Predictability and Mutual Fund Dynamics: How Managers Use Predictors in Changing the Systematic Risk Il sistema dualistico per la governance di banche e assicurazioni Precautionary investments and vertical externalities: the role of private insurers in intergovernmental relations I derivati climatici per il settore vitivinicolo Market discipline in the banking industry. Evidence from spread dispersion A Survey on Risk Management and Usage of Derivatives by Non-Financial Italian Firms Hedge Funds: Ability Persistence and Style Bias Cross-Industry Diversification: Integration, Bubble and Predictability The Impact of Government Ownership on Banks’ Ratings: Evidence from the European Banking Industry A Framework for Assessing the Systemic Risk of Major Financial Institutions Multidimensional Distance to Collapse Point and Sovereign Default Prediction Search Costs and Mutual Fund Fee Dispersion The Choice of Target’s Advisor in Mergers and Acquisitions: the Role of Banking Relationship Stochastic Mortality: the Impact on Target Capital Regular(ized) Hedge Fund Clones Loads and Investment Decisions The role of Basel II in the subprime financial crisis: guilty or not guilty? Why Larger Lenders obtain Higher Returns: Evidence from Sovereign Syndicated Loans Crisi finanziaria, controlli interni e ruolo delle Autorità Why do foreign banks withdraw from other nations Do derivatives enhance or deter mutual fund risk-return profiles? Evidence from Italy External Debt to the Private Sector and the Price of Bank Loans
9/09
10/09 11/09 12/09
13/09 14/09 15/09 16/09 17/09 18/09 19/09
20/09 21/09 22/09
23/09 24/09 01/10
02/10
03/10
04/10 05/10 06/10 07/10
Pricing insurance contracts following the cost of capital approach: some conceptual issues Listed Private Equity Funds: IPO Pricing, J-Curve and Learning Effects Rating changes: the European evidence Beyond macroeconomic risk: the role of contagion in the italian corporate default correlation Revisiting corporate growth options in the presence of state-dependent cashflow risk Borrowing in Buyouts Explaining Returns in Private Equity Investments Banks’Loan Loss Provisioning: Procyclical Behaviour and Potential Solutions Informed intermediation of longevity exposures Regulations and soundness of insurance firms: international evidence Project Finance Collateralised Debt Obligations: An Empirical Analysis on Spreads Determinants Crashes and Bank Opaqueness Investors’ Distraction and Strategic Repricing Decisions Italian labourers participation in private pension plans: an analysis of closed funds targeting specific industries Diritto delle assicurazioni e diritto europeo: la prospettiva italiana The Common Frame of Reference (CFR) of European Insurance Contract Law Optimal time of annuitization in the decumulation phase of a defined contribution pension scheme Three make a smile – dynamic volatility, skewness and term structure components in option valutation On the role of behavioral finance in the pricing of financial derivatives: the case of the S&P 500 Stabilizing Large Financial Institutions with Contingent Capital Certificates Performance in private equity: why are general partnerships’ owners important? Operational Risk Modeling: An Evaluation of Competing Strategies Ownership Structure, Board Composition And Investors’ Protection: Evidence From S&P 500 Firms
08/10 Towards A New Framework For Liquidity Risk 09/10 Too-Big-to-Fail” and its Impact on Safety Net Subsidies and Systemic Risk 10/10 Private benefits of control in the banking industry: a cross-country analysis 11/10 Reaching Nirvana With A Defaultable Asset? 12/10 Measuring Systemic Risk in the Finance and Insurance Sectors 13/10 On Regulation, Supervision, (De)leveraging and Banking Competition: Harder, Better, Faster, Stronger? 14/10 Variable Annuities: Risk Identification and Risk Assessment 15/10 CEO Remuneration and Bank Default Risk: Evidence from the US and Europe 16/10 The Basel Committee Proposals For Capital Adequacy Reform: A Critical Analysis
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