Bank Regulations – Why the Current Approach Will Fail
The 2008 banking collapse, leading to the most severe recession since 1929, prompted a wide-ranging set of efforts to insure it did not happen again. These actions have included requiring banks to hold larger cash balances and more precise definitions of the risk levels of various bank assets. The result? A new industry of “risk” professionals working for banks and bank regulators has emerged. Here, I spell this out in more detail, explain why it will not work and what should be done.
The ABCs of Bank Regulation
Banks take in cash as deposits. They are required to keep less than 10% of these on hand to cover the normal fluctuations between new deposits and withdrawals. The rest of their deposits (90%+) remain for bank investments. In the past, banks were supposed to cover most of their costs via the “spread” – the difference between what they could earn on their investments and what they had to pay to attract deposits. Banks knew their very survival depended on the safety of their investments (mostly loans to businesses and mortgages). As a consequence, they took great care to make sure they made safe investments. Any old time banker will tell you the bank staff spent a good deal of time making sure their borrowers were OK and helping them in any way they could.
In 1999, provisions of the Glass-Steagall Act that prohibit a bank holding company from owning other financial companies were repealed. As a result, banks have increasingly “bundled” their investments and sold them off for commissions. Note what this does to the internal incentive structures of banks: instead of having their very existence depending on the safety of their investments, generating commissions gets top priority. So how can banks maximize commission income? By making as many loans as they can and selling them off. So what then happens to banks’ concern over the safety of their loans? It disappears: just make as many loans as possible and sell them off for commissions.
Enter the Basel Accords
The Basel Accords are an attempt to regulate bank safety by providing different “safety weights” to bank assets. Countries do not need to apply them but most European Union countries do and the US regulations approximate whet the Accords require. Even though there are now three Accords with a fourth on the way, their essence is encapsulated in the 1988 Basel I Accord. Basel I created a bank asset classification system. This classification system grouped a bank’s assets into five risk categories:
• 0% (no risk) – cash, central bank and government debt and any OECD government debt;
• 0%, 10%, 20% or 50% – public sector debt;
• 20% – development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (under one year maturity) and non- OECD public sector debt, cash in collection;
• 50% – residential mortgage packages/derivatives;
• 100% – private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and equipment, capital instruments issued at other banks.
These weights were applied to a bank’s assets. Their total is called a bank’s risk-weighted assets (RWA). Banks were required to maintain capital (cash or near-cash) on hand equal to at least 8% of its risk-weighted assets. For example, if a bank has risk-weighted assets of $100 million, it is required to maintain capital of at least $8 million. Since 1988, the regulations have grown and become increasingly complex.
The banking collapse of 2008 led to a ratcheting up of bank regulations. The clearest manifestation of this was passage of the Dodd-Frank Act (2010) that applies numerous new restrictions and reporting requirements on banks. One indication of just how complex things have gotten is seen in the growing length of the annual reports of major banks. In 2007, the JPMorgan Chase annual report was 192 pages. In 2016, it was 328 pages, with most of the additional pages explaining how they complied with regulations.
A taste of what this entails can be gained via excerpts from the 2016 report:
As of December 31, 2016 and 2015, the lower of the Standardized or Advanced capital ratios under each of the Transitional and Fully Phased-In approaches represents the Firm’s Collins Floor, as discussed in Monitoring and management of Capital section:
• The Tier 1 leverage ratio is calculated by dividing Tier 1 capital by adjusted average assets.
• The SLR leverage ratio is calculated by dividing Tier 1 capital by SLR leverage exposure.
• Represents the Transitional minimum capital ratios applicable to the Firm under Basel III as of December 31, 2016 and 2015. At December 31, 2016, the CET1 minimum capital ratio includes 0.625% resulting from the phase-in of the Firm’s 2.5% capital conservation buffer and 1.125%, resulting from the phase-in of the Firm’s 4.5% global systemically important banks (“GSIB”) surcharge.
• Represents the minimum capital ratios applicable to the Firm on a Fully Phased-In Basel III basis. At December 31, 2016, the ratios include the Firm’s estimate of its Fully Phased-In U.S. GSIB surcharge of 3.5%. The minimum capital ratios will be fully phased-in effective January 1, 2019. For additional information on the GSIB surcharge, see page 79. (e) In the case of the SLR, the Fully Phased-In minimum ratio is effective beginning January 1, 2018.
Another example: Here is how the bank explains its “value-at-risk measure:”
JPMorgan Chase utilizes VaR, a statistical risk measure, to estimate the potential loss from adverse market moves in a normal market environment. The Firm has a single VaR framework used as a basis for calculating Risk Management VaR and Regulatory VaR. The framework is employed across the Firm using historical simulation based on data for the previous 12 months. The framework’s approach assumes that historical changes in market values are representative of the distribution of potential outcomes in the immediate future. The Firm believes the use of Risk Management VaR provides a stable measure of VaR that is closely aligned to the day-to-day risk management decisions made by the lines of business, and provides the appropriate information needed to respond to risk events on a daily basis. The Firm’s Risk Management VaR is calculated assuming a one-day holding period and an expected tail-loss methodology which approximates a 95% confidence level. Risk Management VaR provides a consistent framework to measure risk profiles and levels of diversification across product types and is used for aggregating risks and monitoring limits across businesses. Those VaR results are reported to senior management, the Board of Directors and regulators. Under the Firm’s Risk Management VaR methodology, assuming current changes in market values are consistent with the historical changes used in the simulation, the Firm would expect to incur VaR “back-testing exceptions,” defined as losses greater than that predicted by VaR estimates, on average five times every 100 trading days. The number of VaR back-testing exceptions observed can differ from the statistically expected number of back-testing exceptions if the current level of market volatility is materially different from the level of market volatility during the 12 months of historical data used in the VaR calculation. Underlying the overall VaR model framework are individual VaR models that simulate historical market returns for individual products and/or risk factors. To capture material market risks as part of the Firm’s risk management framework, comprehensive VaR model calculations are performed daily for businesses whose activities give rise to market risk. These VaR models are granular and incorporate numerous risk factors and inputs to simulate daily changes in market values over the historical period; inputs are selected based on the risk profile of each portfolio, as sensitivities and historical time series used to generate daily market values may be different across product types or risk management systems. The VaR model results across all portfolios are aggregated at the Firm level. Since VaR is based on historical data, it is an imperfect measure of market risk exposure and potential losses, and it is not used to estimate the impact of stressed market conditions or to manage any impact from potential stress events. In addition, based on their reliance on available historical data, limited time horizons, and other factors, VaR measures are inherently limited in their ability to measure certain risks and to predict losses, particularly those associated with market illiquidity and sudden or severe shifts in market conditions. For certain products, specific risk parameters are not captured in VaR due to the lack of inherent liquidity and availability of appropriate historical data. The Firm uses proxies to estimate the VaR for these and other products when daily time series are not available. It is likely that using an actual price-based time series for these products, if available, would affect the VaR results presented. The Firm therefore considers other measures such as stress testing, in addition to VaR, to capture and manage its market risk positions. The daily market data used in VaR models may be different than the independent third-party data collected for VCG price testing in its monthly valuation process. For example, in cases where market prices are not observable, or where proxies are used in VaR historical time series, the data sources may differ (see Valuation process in Note 3 for further information on the Firm’s valuation process). Because VaR model calculations require daily data and a consistent source for valuation, it may not be practical to use the data collected in the VCG monthly valuation process for VaR model calculations. The Firm’s VaR model calculations are periodically evaluated and enhanced in response to changes in the composition of the Firm’s portfolios, changes in market conditions, improvements in the Firm’s modeling techniques and measurements, and other factors. Such changes may affect historical comparisons of VaR results. For information regarding model reviews and approvals, see Model Risk Management on page 128. The Firm calculates separately a daily aggregated VaR in accordance with regulatory rules (“Regulatory VaR”), which is used to derive the Firm’s regulatory VaR-based capital requirements under Basel III. This Regulatory VaR model framework currently assumes a ten business-day holding period and an expected tail loss methodology which approximates a 99% confidence level. Regulatory VaR is applied to “covered” positions as defined by Basel III, which may be different than the positions included in the Firm’s Risk Management VaR. For example, credit derivative hedges of accrual loans are included in the Firm’s Risk Management VaR, while Regulatory VaR excludes these credit derivative hedges. In addition, in contrast to the Firm’s Risk Management VaR, Regulatory VaR currently excludes the diversification benefit for certain VaR models.
Here are the acronyms used by JP Morgan in their report:
AFS, ALCO, AWM, AOCI, ARM, AUC, AUM, BHC, CB, CBB, CCAR, CCB, CCO, CCP, CDS, CEO, CET1, CFTC, CFO, CIB, CIO, CLO, CLTV, COO, CRO, DFAST, DOJ, DOL, DRPC, DVA, ERISA, EPS, ETD, EU, FASB, FDIA, FFELP, FFIEC, FHA, FICO, FRC,. FSB, FTE, FVA, FX, GSE, GSIB, HAMP, HELOAN, HELOC, HQLA, HTM, ICAAP, IDI, IHC, ISDA, LCR, LDA, LGD, LIBOR, LLC, LOB, LTIP, LTV, MBS, MD&A, MMDA, MSA, MSR, NA, NAV, NM, NOL, NOW, NSFR, OAS, OCC, OCI, OEP, OIS, OPEB, ORMF, OTTI, PCA, PCI, PD, PRA, RCSA, REIT, REO, RHS, ROA, ROE, ROTCE, RSU(s), RWA, S&P, SEC, SLR, SMBS, SOA, SPEs, TBVPS, TCE, TDR, TLAC, U.K, LCR, VA, VaR, VCG, VGF, VIEs.
The above is a lot of hocus-pocus signifying nothing.
The Regulations Have Not Worked
As noted above, since 1988, banking regulations have been increased. They have not worked. They did not protect the banking system from collapse. Why? Because regulators did not anticipate and insert safeguards against what would be risky assets. In 2008, nobody anticipated that the market for adjustable-rate mortgages and other asset backed securities would disappear overnight.
Will the new regulations be better? To answer this question, consider the latest (Basel IV) regulations summarized below in a McKinsey Global Research article:
Capital floors (BCBS 306/BCBS 362). Replacement of the transitional Basel I floor framework with a new capital floor based on the SA: the floor is meant to mitigate model risk and measurement error stemming from internally modeled approaches. It would enhance the comparability of capital outcomes across banks and ensure that the level of capital across the banking system does not fall below a certain level. The BCBS announced a calibration range of the floor of 60-90 percent.
Credit risk standardized approach (BCBS 347). Adjustment of the credit risk SA to appropriately reflect riskiness of exposure. It increases comparability of capital requirements under the credit risk SA and the IRB approaches and reduces reliance on external ratings. (For exposures to financial institutions and corporates, banks must perform due diligence on their counterparties to assess the reliability of the external rating; for real estate exposures, a new regulatory-risk weight-mapping table is introduced, focusing on the loan-to-value ratio.)
Fundamental review of the trading book (BCBS 352). Strengthening capital standards for market risk—in particular, by better capturing tail and liquidity risks and by fostering a consistent implementation of standards at the intersection of the banking and trading books. This becomes effective by 2019.
Operational risk standardized measurement approach (BCBS 355). Revised standard for operational risk, replacing all existing operational risk measurement approaches. This new standardized measurement approach (SMA) mainly consists of a revised business indicator, new size-based risk coefficients instead of segment-based risk coefficients, and a loss component that accounts for observed operational losses.
Reduction of variation in RWA (BCBS 362). Revisions to the advanced IRB and the
F-IRB approaches. The proposals include complementary measures that aim to reduce complexity, improve comparability, and address excessive variability in the capital requirements for credit risk. Among other measures, the BCBS considers removing the option to use the IRB approaches for certain exposures (for instance, financial institutions, large corporations, and equities), where it is judged that the model parameters cannot be estimated sufficiently reliably for regulatory capital purposes. Furthermore, proposals include adoption of exposure-level, model-parameter floors to ensure a minimum level of conservatism for portfolios where the IRB approaches remain available and to provide greater specification of parameter estimation practices to reduce variability in risk weights.
Further regulatory initiatives:
• Risk weighting of sovereign exposures.
• Introduction of regulatory capital requirements for banks investing in governments solely based on external ratings: in the EU, IRB approach banks are allowed to treat their sovereign exposures permanently under the SA rules. Under the current credit risk SA, a zero risk weight applies to sovereign exposures regardless of their denomination and funding currency as long as the counterparty is an EU member state. For now, the BCBS has explicitly excluded this kind of debate from its revised credit risk SA consultations.
IFRS 9. Replacement of the current accounting standard IAS 39 for financial instruments and introduction of a new framework for classification, impairments, and hedge accounting, becoming effective in 2018. Introduction of lifetime expected loss and earlier provisioning might require substantial risk IT adjustments and increase of current provisioning levels.
Supervisory review and evaluation process (SREP). Harmonization of Pillar-2 supervision of all institutions across the EU. It ensures that institutions have adequate arrangements, strategies, processes, and mechanisms as well as capital and liquidity to ensure sound management and coverage of their risks, including those revealed by stress testing.
Note the highlighted part in the above. Several years back in writing about the Greek crisis, I asked who was buying Greek government debt after it became patently obvious that the country was in serious economic trouble. I quote from what I learned:
The Basel II rules governing Eurozone banks at that time allowed them to include government debt as part of their reserves. In short, the rules allowed government debt to be considered as safe as cash! So understandably, the banks said why hold cash when we can buy Greek debt and get a healthy return? You might wonder why the banks’ “risk officers” did not point out just how risky Greek debt was. They probably did but were overruled. They were ignored until the market for these securities vanished overnight. And the regulators – where were they?
The highlighted section from above repeated:
Under the current credit risk SA, a zero risk weight applies to sovereign exposures regardless of their denomination and funding currency as long as the counterparty is an EU member state. For now, the BCBS has explicitly excluded this kind of debate from its revised credit risk SA consultations.
In short, “sovereign exposures” such as Greek debt continue to be considered as safe as cash!
So will more regulation help? Most certainly, they will make banks jump through more hoops. But greater safety? Probably not because the regulators cannot anticipate where the future risks will come from.
There Is Another Solution – Change Bank Incentives
As mentioned above, bank incentives changed fundamentally in 1999 when banks started to focus on commissions as their primary source of income. Under the maximize commissions model, the concerns over loan quality disappear completely, as it did leading up to the 2008 bank collapse. And many of the problems following the collapse stemmed from the fact that nobody knew how risky the mortgages were in the packages that were trading.
It now appears that back in 1933, Glass and Steagall were right: banks should not be allowed to “gamble” with our deposits. The only real solution is to require banks to hold on to the loans they make and not engage in financial trading. Their trading arms should be spun off as they were in 1933. If the survival of banks depends on the loans they make, they will make safe loans.
So why will the changes proposed above not happen? Banks are not really concerned with more regulations. They will just hire more staff to deal with them. The problem is that if we went back to Glass-Steagall, bank profits would be lower and they could not afford to pay their senior executives what they now receive.