Is this a case of too little too late as some have implied or a pragmatic compromise between maintaining financial stability and ensuring robust economic growth? Let’s examine the key provisions of the proposed regulations to assess its impact on the banking sector and consequently on credit costs / credit availability.
I. Minimum capital requirements – more than 3 fold increase to core equity
The minimum capital for common equity, the highest form of loss absorbing capital, will be raised from the current 2% level, before the application of regulatory adjustments to 4.5%, after the application of regulatory adjustments. This increase will be phased in to apply from Jan 1, 2015.
In addition to the above, the committee recommended a 2.5% of additional core equity capital as a conservation buffer above the regulatory minimum taking the aggregate minimum core equity required to 7%. The conservation buffer is also phased in to apply from Jan 1, 2016 and will come into full effect from Jan 1, 2019.
Certain regulatory deductions (material holdings, deferred tax assets, mortgage servicing rights etc) that are currently applied to tier 1 capital and/or tier 2 capital or treated as RWA will now be deducted from Core equity capital. This will also be progressively phased in over a five year period commencing 2014.
Phasing-in effect:
2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | |
Minimum core equity | 3.5% | 4.0% | 4.5% | 4.5% | 4.5% | 4.5% | 4.5% |
Conservation buffer | .625% | 1.25% | 1.875% | 2.5% | |||
Total core equity | 3.5% | 4.0% | 4.5% | 5.125% | 5.75% | 6.375% | 7.0% |
Min. total capital incl. buffer | 8.0% | 8.0% | 8.0% | 8.625% | 9.25% | 9.875% | 10.5% |
Phasing in of other deductions from core T1 | 20% | 40% | 60% | 80% | 100% | 100% | |
Counter cyclical buffer | In addition the regulator can specify a counter cyclical buffer of up to 2.5% of fully loss absorbing capital for macro prudential objectives | ||||||
Regulatory buffers, provisions, and cyclicality of the minimum
The capital conservation buffer should be available to absorb banking sector losses conditional on a plausibly severe stressed financial and economic environment. The countercyclical buffer would extend the capital conservation range during periods of excess credit growth, or other indicators deemed appropriate by supervisors for their national contexts. Both buffers could be run down to absorb losses during a period of stress.
Deductions from Core Tier 1
- Minority interest - The excess capital above the minimum of a subsidiary that is a bank will be deducted in proportion to the minority interest share.
- Investments in other financial institutions - The gross long positions may be deducted net of short and the proposals now include an underwriting exemption.
Other deductions
The other deductions from Common Equity Tier 1 are: goodwill and other intangibles (excluding Mortgage Servicing Rights), Deferred Tax Assets, investments in own shares, other investments in financial institutions, shortfall of provision to expected losses, cash flow hedge reserve, cumulative changes in own credit risk and pension fund assets.
The following items may each receive limited recognition when calculating the common equity component of Tier 1, with recognition capped at 10% of the bank’s common equity component:
- Significant investments in the common shares of unconsolidated financial institutions (banks, insurance and other financial entities). “Significant” means more than 10% of the issued share capital;
- Mortgage servicing rights (MSRs); and
- Deferred tax assets (DTAs) that arise from timing differences.
The combined effect of the above is shown below:
Capital instruments that do not meet qualifying criteria for inclusions in non-core tier 1 capital (i.e no incentive to redeem, full loss absorption capacity, full discretion on coupon payments etc) will be progressively phased out at an amortization rate of 10% p.a. effective Jan 1, 2013 to the earliest call date after which it will fully be derecognised if not called.
Only one type of tier 2 capital and the terms will have no incentive to redeem (i.e. no step-ups in coupons).
III. Leverage Ratios
A. Definition of the leverage ratio
The Committee is proposing a minimum Tier 1 leverage ratio of 3% during the parallel run period. While there is a strong consensus to base the leverage ratio on the new definition of Tier 1 capital, the Committee will also track the impact of using total capital and tangible common equity.
Off-balance-sheet (OBS) items, use uniform credit conversion factors (CCFs), with a 10% CCF for unconditionally cancellable OBS commitments (subject to further review to ensure that the 10% CCF is appropriately conservative based on historical experience).
Derivatives (including credit derivatives), apply Basel II netting plus a simple measure of potential future exposure based on the standardised factors of the current exposure method.
B. Transition to the leverage ratio
The supervisory monitoring period commences 1 January 2011. The parallel run period commences 1 January 2013 and runs until 1 January 2017. Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.
IV. Liquidity
A. Liquidity coverage ratio (LCR)
The stock of liquid assets should be higher than the projected liquidity outflow over a 30 day time period.
Definition of liquid assets: The proposal outline that the assets must be available for the treasurer of the bank, unencumbered, and freely available to group entities. As part of the narrow definition of liquid assets, the proposal allow for the inclusion of domestic sovereign debt for non-0% risk weighted sovereigns, issued in foreign currency, to the extent that this currency matches the currency needs of the bank’s operations in that jurisdiction.
Allow Level 2 of liquid assets with a cap that allows up to 40% of the stock to be made up of these assets. Include (with a 15% haircut) government and PSE assets qualifying for the 20% risk weighting under Basel II’s standardised approach for credit risk, as well as high quality non-financial corporate and covered bonds not issued by the bank itself (eg rated AA- and above), also with a 15% haircut.
Retail and SME deposits: Lower the run-off rate floors to 5% (stable) and 10% (less stable), respectively. These numbers are floors and jurisdictions are expected to develop additional buckets with higher run-off rates as necessary.
Operational activities with financial institution counterparties: Introduce a 25% outflow bucket for custody and clearing and settlement activities, as well as selected cash management activities.
Deposits from domestic sovereigns, central banks, and public sector entities:
For unsecured funding, treat all (both domestic and foreign) sovereigns, central banks and PSEs as corporates (ie with a 75% roll-off rate), rather than as financial institutions with a 100% roll-off rate.
For secured funding backed by assets that would not be included in the stock of liquid assets, assume a 25% roll-off of funding.
Secured funding: Only recognise roll-over of transactions backed by liquidity buffer eligible assets.
Undrawn commitments: Lower retail and SME credit lines from 10% to 5%. Treat sovereigns, central banks, and PSEs similar to non-financial corporates, with a 10% run-off for credit lines and a 100% run-off for liquidity lines.
Inflows: Rather than leave it to the bank’s discretion to determine the percentage of “planned” net inflows, establish a concrete harmonised treatment in the standard that reflects supervisory assumptions.
B. Net stable funding ratio (NSFR)
The main concerns related to the calibration of the standard and the relative incentives across business models, in particular retail versus wholesale. A number of adjustments are under consideration.
V. Counterparty credit risk
The Committee is making modification to the treatment of counterparty credit risk, including the bond equivalent approach to calculating the credit valuation adjustment (CVA). The bond equivalent approach will be amended to address hedging, risk capture, effective maturity and double counting. To address the excessive calibration of the CVA, the 5x multiplier that was proposed in December 2009 will be eliminated. More advanced alternatives to the bond equivalent approach could be considered as part of the fundamental review of the trading book.
Banks’ mark-to-market and collateral exposures to a central counterparty (CCP) should be subject to a modest risk weight, for example in the 1-3% range, so that banks remain cognisant that CCP exposures are not risk free.
VI. Systemic banks, contingent capital and a capital surcharge
In addition to the reforms to the trading book, securitisation, counterparty credit risk and exposures to other financials, the Group of Governors and Heads of Supervision agreed to include the following elements in its reform package to help address systemic risk:
The Basel Committee has developed a proposal based on a requirement that the contractual terms of capital instruments will allow them at the option of the regulatory authority to be written-off or converted to common shares in the event that a bank is unable to support itself in the private market in the absence of such conversions. At its July meeting, the Committee agreed to issue for consultation such a “gone concern” proposal that requires capital to convert at the point of non-viability.
It also reviewed an issues paper on the use of contingent capital for meeting a portion of the capital buffers. The Committee will review a fleshed-out proposal for the treatment of “going concern” contingent capital at its December 2010 meeting.
SUMMARY
The short term implications are muted as the implementation timeline is phased over 8 years to ensure that economic growth is not threatened. But the combined impact of the above proposals will have significant long term implication for bank profitability, availability of credit, cost of credit and would challenge the current wholesale bank model (GS, MS, GE Capital etc)…..
While attempting to make the financial sector stable, the central bankers are driving the insurance premium too high for the banks and its customers. It remains to be seen when they would be rushing into Basel 4 to address the adverse impact of Basel 3 on credit availability and credit costs.
A more effective deterrent would have been to make bank’s board personally liable for negligence and mismanagement! That would, in my opinion, lead to good governance standards….more than any amount of rules can ever achieve!!
Any takers????????
Sridhar,
ReplyDeleteTo undo 20 years of self regulation which lead to the GFC, sometimes a harsh pill is required. I do agree that the combained effect may weigh down on long term growth, but stability of the Financial system is more important than cheap credit and grown
Banking has never been self regulated, you could say ineptly regulated by bureaucrats who did not understand some of the complex structured instruments that were peddled in the name of financial innovation.
ReplyDeleteWhile the ultimate objective is to deliver a stable functioning financial system, the measures should not be too stringent to pay for or offset inefficiencies of the regulator. Its like saying we can increase taxes but will not cut government spending...
Somebody has to pick up the tab and it will sadly be the consumer in the end in one form or another.
What would be more appropriate would be to institute self correcting measures that penalise negligence and mismanagement through setting up personal liability for senior management.
Hi Sridhar, really enjoy your posts.
ReplyDeleteOn countercyclical capital buffers, I don't think CCCBs are a good idea - what the market sees is RWA, and should you use up your CCCB all the market will see is a declining capital ratio. Even making public "it's our buffer we are using" seems pointless - it doesn't matter what we "call" capital. No firm will want to deliberately reduce its capital ratios even if encouraged to do so by a regulator. What's more, the presumption is that, the reason banks shy away from lending in downturns is that they don't have enough capital, but in addition it's that there are fewer value-adding loans to be made.
For CCCBs to work, they need to so absurdly huge that analysts don't talk about capital ratios anymore...maybe if Mervyn gets his way that will happen...
You can solve both problems by provding government guarantees on loans and building into regulation that such loans have very low RWA. Banks won't take on more risk just because they have more capital.
Some other thoughts, some due to Tom sandall:
So, some thoughts:
Bonuses
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Ah, here we can kill several birds with one stone - CS had a go at this.
Why not make bonuses a forced loan to the bank; the employee receiving interest around 10%/11% - say the going rate for a CoCo. If the bank's capital ratios fall below a trigger, then the loan becomes shares; otherwise it matures and the principal is repaid, say in 3 years?...any takers?...or will this spawn a new class of banking consultant, on contingent contracts and free of nasty regulation?
Narrow banking
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The narrow banking proposals are unclear. I view them as a vanilla securisation with a single tranche of “notes” issued in different maturities linked to the tenor of underlying assets. This means that each depositor would have the following risks:
A direct pass through of credit risk of whatever assets are held (potentially a pool of those assets with the same tenor as the deposit unless there is some complex credit risk sharing across tenor buckets)
Market risk on selling the deposit instrument early – and by this I specifically mean the borrower is exposed to the sentiment within the market.
It is not clear whether any separate equity or credit insurance is required for a narrow bank – if there is no equity this organization is effectively a mutual society (as retained profits will become a capital buffer over time).
I don’t see that this necessarily protects depositors from risk as the bank could easily originate very risky assets or underprice assets’ risk. Furthermore for any deposit over 1 day maturity the depositor will have to take the supply and demand and sentiment influenced market price on the day. (A lot of the recent debate assumes we can always spot risky things before losses emerge...I wish...)
The support for this idea mentioned - “no possibility of alchemy” just seems to mean this would also remove the possibility for the bank to invest in intrinsically levered instruments (CDO tranches, derivatives).
Note: there is nothing intrinsic to narrow banking that says you cannot narrowly invest deposits in CDOs of the same tenor, or anything to stop the bank from being “levered” itself .in fact (unless equity is required, which is the same old problem being addressed by BIII et al, on which narrow banking has nothing to say) - a narrow bank is *100% levered* (!) and a single dollar loss on the assets will affect the depositors.
Paul H
Leverage
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Tom: MM doesn’t work with (1) TBTF (2) belief by shareholders they can sell before losses priced in (2) agency costs. Making MM work would provide a proper incentive to reduce leverage. Making senior creditors inviolable (as seen in Ireland recently) because that makes the daisy chain of credit keep ….er, turning … (apols - mixed metaphor) ... stops the market from being able to embrace rationality, and prevents bank share prices rewarding good behaviour.
Point (2) above I suppose slightly speaks against the agency cost issue, given my earlier points on low liquidity of bank shares. Also, I don’t think bank investors are quite the analogue of mutual fund investors (as I said last email) as mutual fund investors are not leveraged. Even hedge fund investors are not as leveraged as bank investors.
Banks look too similar and that's a problem
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(Haldane) "If banks are too similar, they will all fail at the same time, and that makes the system unstable".
This is verging on tautology ("similar = identical = must fail at same time").
First of all, it is not necessarily true.
Consider two "concentrated" banks (S and H), different from one another. Define system failure as them both failing
Probability system fails = Prob(S fails) * Prob(H fails | S fails).
The difference between the second term and Prb(H fails) illustrates correlation.
Haldane's assertion is that, suppose, in the name of diversification, these two banks become very similar, but individually less risky. Then while the first term, Prob(S fails) goes down, the second term approaches 1, and hence the probability the system fails increases.
I can see why it's tempting to agree (just thinking about the magnitude of the numbers), but I can construct examples where it is not.
I do like this idea, but it may be flawed - so here's my 2 cents worth.
1. Fallacy - diversified/Universal banks will look the same. This assertion rests on the assumption that in the pursuit of diversification, banks will look the same. This assumes a unique solution to "how diversified should we be". In my opinion, banks need to be allowed to have independent risk appetites and position themselbes along the risk-return spectrum efficient frontier. They won't (necessarily) do this at the same point on the frontier.
Unfortunately, capital regulation itself does not allow banks to have an independent risk appetite - forcing similarity by giving all banks the same model of risk and then imposing increasingly binding constraints on capital to RWA. Formulaic RWA is creating the kind of similarity you don't want! Moreover, unregulated entities - which do not have to use RWA - will arbitrage banks by selling risky assets flattered by RWA; and vice versa.
Conclusion: you should allow banks to choose their business models, Universal or not. Competition should dictate the differences between model - no banks want to compete for exactly the same assets in the same ways as this creates price competition; Universal banks will product differentiate if they are allowed to do so to ameliorate price competition. And it only takes two price competing firms to generate competitve equilibrium prices.
2. Fallacy: systemic stability emerges from splitting up banks into differentiated units. Banks are legal entities and counterparties. Their standalone risk matters. A less risky bank will fund itself cheaper (with or without with TBTF). Therefore, the incentive to differentiate is a great, natural benefit to an individual bank to being less risky than its competitors. I have not thought through the exact implications of this, but riskier banks are less attractive legal counterparts (and cannot provide credit protection to the same degree as a diversified bank).
Cheers, and that's random musing for you!
Paul H