Monday, 14 June 2010

Regulatory Reform – Is the pendulum swinging in extreme?

The scope and scale of the proposed regulatory reforms, while some of it necessary, will place enormous burden on the financial sector which will in turn impact availability of credit and threaten the fragile economic growth. Let’s examine:
A. The primary causes for the financial crisis
B. The overall regulatory objective
C. The proposed regulatory measures and its impact
D. The appropriateness / proportionality of the measures

A. Financial Crisis – ‘Sub-prime or House of Cards’

This was essentially a one-way bet on house prices to continue to rise. Institutions that did not originate these loans, bought structured instruments, the performance of which was linked to the underlying mortgages. The quantitative models used to assess the probability of default of the underlying mortgage contracts or the loss in the event of default was woefully inadequate. In the end, the original loans were taking experiencing larger losses than predicted, and the market value of the securities collapsed as it became apparent the assigned credit ratings were way off.

Some financial institutions were unable to absorb the losses and/or to meet their payment obligations as they fell due (margin/collateral calls) as no wholesale funding was available. As some financial institutions looked less credit worthy their peers did not want to lend them either; there was a round of secondary effects with consequent impact in the real economy…and ultimately recession. This has led to an unprecedented level of taxpayer support for banks, directly to add capital and indirectly by preventing defaults.

Embarrassingly, all this happened immediately subsequent to the implementation of a “risk sensitive” capital accord (“Basel II”) specifically designed to ensure banks were adequately capitalised! The Accord fell flat on its face at the first hurdle. Somehow, banks were still over leveraged!

B. Overall Regulatory Objective

Although not explicitly expressed these are generally held to be threefold: Financial Stability, Market confidence and Consumer protection. The market failures that are generally associated with these objectives are:
• Negative externality, Information asymmetry and Market power (Cartel)

Negative externalities occur when decisions adopted do not take account all the costs which result from a firms actions but which are not borne by the firm. In this case the possibility of market and funding liquidity drying up was not adequately taken into account. Reliance on rating agencies drove risk taking decisions without full deliberation of systemic consequences if underlying assumptions were incorrect. Therefore this would appear to be a relevant market failure.

Information asymmetry also played a part. Firms became wary of their counterparties because they did not have a full picture of their exposures to particular exposure classes or understand the level of leverage counterparty may be running. As a result the inter-bank market dried up. Information asymmetry, therefore, would also appear to be a relevant market failure.

Market power is exercised when prices are changed solely by the decision of a few market players. This in itself is less of an issue within the financial sector.

C. Regulatory Proposals

In particular, what risks do the proposed reforms pose both to banks individually and to the economy as a whole? Let’s examine the proposed regulatory reform under the following main themes:

1. Raising the quality, consistency and transparency of the capital base - The key changes with respect to the capital structure in the proposed regulations are:
• Most regulatory deductions (like goodwill and intangibles, minority interests, deferred tax assets, shortfall of EL vs. provisions) to come from Core tier 1 as opposed to Tier 1 and/or Total capital currently;
• Tighter conditions for hybrid capital (relating to discretion on cumulative coupons/ dividends, permanence, no incentive to redeem and loss absorption capacity) to qualify as Tier 1 capital; and
• Leverage ratio limit

The impact of the changes will undoubtedly lead to a significant increase in the requirement of maintaining core equity and hence would increase the cost of capital for banks and hence the cost of credit to the industry.

Hybrid capital - The changes proposed to the hybrid capital make sense. I strongly believe that write-downs should be temporary and capable of being written back up upon liquidation. A permanent write down would mean that the non-Core Tier 1 capital was subordinate to Common equity and that holders could not share in the recovery of the bank or any liquidation proceeds.

Deductions from capital- It is not necessary that all of the regulatory adjustments applied to regulatory capital should be made from Core Tier 1 capital. A number of the deductions considered in the consultation paper do have value on a going concern basis but arguably less so on a gone concern basis. The Committee should re-consider this particularly bearing in mind the possibility that application of the proposed deductions could exacerbate cyclicality.

Leverage Ratio - Leverage built up for a number of reasons, in particular, the availability of cheap money over a sustained period of time. Leverage then amplified the downward pressure on asset prices as liquidity dried up, thereby puncturing the asset bubble. This led to increased margin calls, which in turn amplified the downward pressure on asset prices as sales were required to meet margin calls.

However, there are serious concerns over its potential design. There is no recognition for credit risk mitigation in exposures and recognition of other netting arrangements. It also ignores business model, risk appetite, structure, governance and risk management practices and at best is a blunt instrument.

2. Enhancing the risk coverage

Counterparty credit risk - The credit valuation adjustment (CVA) charge, among the many overlapping counterparty risk measures raises more questions. The charge appears to be highly disproportionate and fails to recognise hedging practices. Instead, the focus should be on
1. management and regulation of the Central Clearing House - to ensure the security of collateral/margin;
2. computational ability and capacity to appropriately determine market liquidity and margin levels plus default-fund backing for the products that are to be cleared;
3. the operational capacity and connectivity to manage the business in an automated fashion.

Moreover, the current proposals follow on from significant changes to the Trading Book.

3. Supplementary measures – Large exposures and Concentration risk

The objective of the regime is to provide an appropriate degree of protection against firm failure arising from single name concentration risk in the credit portfolio. As a result the large exposure framework is a preventative measure and therefore it could be argued that the use of a going concern measure is appropriate. However, it is not appropriate to make the definition of capital for large exposures a priority for change at this juncture as this issue is already addressed through Pillar 2 currently.

4. Pro cyclicality and promoting countercyclical buffers- Two areas have been identified as countercyclical measures viz. through the cycle provisioning for expected losses and contingent capital.

Through-the-cycle provisioning for expected credit losses - The regulatory proposals comes up with a requirement for through-the cycle expected loss provisioning over and above the accounting provisions. This effectively leads to forward looking provisioning regime which will not sit with the current accounting regime. In summary the recommended approach is that of expected loss over the life of the portfolio.

Capital buffers and the cyclicality of minimum requirements - The Pillar 1 credit risk framework already includes stress test, which can potentially result in a buffer to cater for an economic downturn. On top of this in Pillar 2, many countries operate on a more severe stress scenario, which further informs the buffer level to be held. It would be inappropriate to create a situation where buffers sit upon buffers trapping capital from its efficient use in the real economy.

At first appealing – surely banks should hold more capital – the efficacy of such a general idea will inevitably lead to sub optimal deployment of capital and hence result in either poorer returns or increased cost to customers. Somebody has to pick up the slack! This is where the contingent capital provides considerable appeal.

Contingent capital - The efficacy of contingent capital as a source of funds in distress has had a lukewarm acceptance from the industry. However, this is an effective and economic way of maintaining ‘capital buffers’ to deal with extreme forms of economic or idiosyncratic stress.

Greater acceptance from the industry is required with respect to the notion of contingent capital and these can come in many forms:
• Contingent convertible bonds – these instruments convert to equity at a pre-determined share price that is at a discount to market price at the time of issue upon the triggering of threshold conditions, usually, core Tier 1 ratio breaching a pre-established level;
• Sub-ordinated bonds with write-down features that have fixed hair cut upon triggering of threshold conditions; these may or may not have write up features

The criticism that is levied for the former is that it might exacerbate the short selling activity at times of distress and cause additional erosion of market confidence. This in my view is a very weak argument as in the event of distress the focus is on survival and if capital is available at a pre-determined price, it provides stability and may in fact mute the market nervousness.

5. Liquidity - The introduction of a short term ratio that focuses on the adequacy of a financial institution’s liquidity buffer in times of stress and a long term ratio that focuses on the structure of its funding is welcome. The development of a harmonised menu of liquidity measures that would be available for regulators to choose from when considering a cross border group is essential as a ‘one size fit all’ approach will fail.

Net Stable Funding Ratio (NSFR) - The objective of encouraging more medium and long term funding is laudable. It is recommended that an approach that recognises that the NSFR is only one of the several measures that needs to be used by supervisors in the evaluation of a firm’s liquidity.

6. Financial stability or ‘Moral Hazard’ ? - The identification, measurement and monitoring of these ‘Significantly Important Financial Institutions’ (SIFIs) is being debated in global, European and national fora. Agreed, large and diverse banks or those whose operations include a high degree of interconnectivity, require careful oversight, given their systemic importance.

However, it is vital to recognise that large and diverse firms bring social, economic, and market benefits, through their capacity to intermediate between borrowers and investors across a range of markets. These firms perform a risk taking function, which is necessary for economic vitality. Large global firms can deliver economies of scale, scope, and improve market efficiency and support global trade.

Addressing systemic importance - There is no ‘silver bullet’ for dealing with SIFIs, and a multi-pronged approach is needed. There is potentially a trade-off between enhancing financial stability and stimulating economic growth so a thorough assessment of the cumulative impact of the proposed measures, in line with changes already in train, is required.

Capital or liquidity surcharges for SIFIs - Additional capital or liquidity surcharges should not be the immediate choice of regulators. As noted, across the board prudential capital and liquidity changes in train will serve to protect against probability of failure.

Placing restrictions on activities or ‘Volcker Rule’ - In the recent crisis diversified firms were able to cope with the crisis better than the monolines. The focus should be on risk management and governance. However, what would be more effective would be a closer review of conflicts of interest within a business model. Also the regulatory approach of higher capital charge for trading activities is appropriate rather than driving these activities into unregulated entities.

Resolution Fund - The creation of a resolution fund to bail out financial institutions would in itself create a moral hazard. It would result in encouraging the kind risk practices that regulations are seeking to rein in. It is appropriate for supervisors to have a common regulatory toolkit and to continue to develop convergence of understanding and approach.

Pillar 2 is the right place to address firm-specific issues but the approach to Pillar 2 requires new thinking from supervisors. Improvements should be made in the Pillar 2 supervisory review and evaluation process with a greater focus on understanding banks’ businesses models and the risks that they could create, individually and collectively, for the financial system.

D. Appropriateness and proportionality

Whilst some of the regulatory developments are necessary, the collective impact of the regulations will result in a significant increase in capital requirements. The current thought process that capital is a panacea for all evils is unpalatable. As a starting point to the debate would like to make the following points:

1. Regulatory oversight - The significant reason for the large scale failure can be attributed to the ‘light touch’ regulation and the collective failure of regulators, rating agencies, bank’s risk management standards. Unabated growth in loans and asset prices should raised enough warning signals for regulators to initiate action to dampen credit.

2. Regulate ‘high risk’ activities - Stipulate higher levels of capital and notional limits for highly risky activities like correlation trading, leveraged financing transaction, underwritten M&A trades, private equity, etc. so that these are supported with capital commensurate with its risk. Sectoral exposure caps or significantly higher capital charge to non regulated entities (like hedge funds, private equity etc.)

3. Address conflicts of interests - Eliminate activities that pose conflicts of interests. For e.g. Investment Banking combined with Asset / Fund management business poses significant conflicts of interest as the entity in lure of fees may originate assets and transfer to managed funds.


The current set of proposed regulations will deliver onerous levels of capital and liquidity buffers and act like a ‘millstone around the neck’. The higher price for capital, as well as the fact that more capital is required, implies a higher cost of credit. This in turn will slow economic growth.

The trade-off between financial stability vs. economic growth has begun! Will it be too much to hope for a balanced result?

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