B2 or not B2? - another long essay!

Adair Turner, Chairman of the FSA (UK's financial regulator) suggests wiping the slate clean and redesigning bank regulation anew in the light of the lessons learned from the present crisis. Cleaning the Augean Stables sounds good to the public and politicians, but it is a Herculean task, in fact impossible and undesirable. It needs restating that global banking was already implementing comprehensive safeguards, Basel II (B2) and the almost identical Solvency II (for insurance firms), which in the EU have the force of law and are now reflected in new IFRS accounting standards. But of B2's three 'pillars' only Pillar I is close to complete implementation (covering credit and market risks for the calculation of minimum regulatory Tier 1 capital). And like generations of any service or product, first generation implementations are not yet as accurate or efficient as the law fully requires. It is on the basis of Pillar II that regulators now demand capital adequacy ratios of 10-12%, that is half as much again as the minimum regulatory capital.
Reasons why Basel II cannot be abandoned, apart from its good sense and the years and many $billions spent on its implementation, include the instant impossibility of extending banking and insurance regulation to 'near-banks' such as hedge funds, and the immense legal risk if the credibility of B2 is junked. How these regulations are improved upon will be driven as much by the hundreds of cases before the law courts as by what regulators decide. We know that banks and non-bank financial institutions over-leveraged and to a great extent because of flaws in ratings agencies credit risk models. One common illegality, however, by banks was to adopt the highest risk grades for securitised assets when the law states that at least 3 grades must be obtained from competing ratings agencies and where they differ the average or middle rating should be adopted. It was in any case absurd that retail banking assets could be repackaged so as to obtain much higher credit risk ratings than when they remained on banks' books secured by capital reserves (replaced by in CDS insurance and standby CP). There was complicity in this by the ratings agencies (see next essay) who, like Moody's, place the blame on bugs in their rating models! Whatever could not be analytically regulated by the financial regulators was in practise regulated (valued) by the ratings agencies, but on a commercial basis, which inevitably invites conflict of interest (reputational risk) for which the ratings agencies are paying in fallen share values (after August 2007) and likely to remain depressed for years by future legal risks!
Banks like hedge funds went ‘long’ on loans and short-term borrowings, often far in excess of what could prudentially be supported by collateral, equity and deposits. Over-leveraging was an implicit, not explicit, part of Basel II’s risk assessments. It could be captured only by calculating how much unsecured assets and liabilities overhung the bank that would require reserve capital if still persisting at the time of end of the accounting and reporting period. The problem with what regulators can see is they only see annual or six monthly data measured at a specific cut-off date, not dynamically over the reporting periods. It is up to the intelligence and principled discretion of a bank to calculate and show internally (if not externally on request) how far assets and liabilities can move within accounting period to be out of touch with capital reserves. This is only captured in a bank's business model expressed as credit limits. The rule of thumb is that if unsupported risk occurs this means risk mitigators (including capital-raising) are in short supply (or prohibitively expensive). But, banks, like hedge funds, do permit short term excesses. This risk sensitivity is the last building block of Basel II - a real-time reporting system to the bank's board whereby excess leverage might be reported for all of a bank’s economic capital model and then adjusted top-down. UBS, Merril Lynch, Citigroup, Bear Stearns, Fortis and Lehman Brothers and others all found structured finance departments did not report bad news until they have exhausted all alternatives to doing so (long common practise in dealing rooms and a reason why Basel I and Basel II were conceived)! This is a treasury risk oversight function, to manage risk-assessed cash-flows. Cash-flow risks in real-time are within Basel II’s scope as periodic default risk and liquidity risk (an aspect of Pillar II still 'under development'!) with as an indicator to the market of a bank in trouble when it's seen borrowing short term at high rates)! When regulators start to look hard at the limitations of Basel II in the context of the present crisis this is a big concern, to ensure transparency and honesty inside banking groups (operational risk) as well as externally (credit and market risk). Internal audits and external auditors have this responsibility too, but periodic formal audits can be gamed, especially when most banks' general ledgers are too old, too limited, to capture all of the latest exposure types. It is no lie when Bradford & Bingley, Fortis, UBS or Lehman Brothers board executives statde they could no see the full picture from their accounts! In wholesale market trading, in the dealing rooms, it is a long established practise by traders to hide losses and work them out over time. This was no longer possible given the scale of sub-prime mortgage backed assets generally and their derivatives after Moody's issued multi-notch downgrades following introduction of a new bug-fixed model after 16 August 2007. But, there is no doubt too that exposures were cack-handedly hidden from many senior managements for many months by use of various fair value subtleties, and therefore there is strength behind the argument that fair value accounting rules should not be relaxed. The only fair value solution is to report mark-to-market values alongside fair value model estimates with explanations for the difference. Right now, however, the first priority is to save the banks and then dictate new detailed solutions. Today, thanks to confidence-boosting efforts by Governments and central banks overnight LIBOR has fallen to 1.5%, but 3-month money is falling more slowly to just above 4%. The Irish Government's guarantee of its banks' interbank borrowing (until 2012) has had a more marked effect in bringing down the perceived longer term risk of loans to banks, with the unexpected consequence that the riskiness of Government debt has risen by the same amount that bank debt's riskiness has fallen! This, rather than actual taxpayers' money invested in banks' equity may be the biggest long term impact of SARP on government budgets?
B2's Pillar I aims to achieve a ratio of 8% capital reserve to risk weighted net assets (loans). This is usually quite enough to survive a recession when loan defaults triple and quadruple and go even much higher. B2's Pillar II is designed to look at how all major risks coincide in severe shocks, or systemic crises, or recession (over the economic cycle) and the B2 P2 calculations therefore form the basis for reserve capital buffers (alongside financial stability analysis by central banks) that currently require another 4% or more of reserve capital generally (enforced by regulators and central banks). UK banks are being advised currently to aim for a total capital reserve (including equity capitalization) of 11.5%. Every % increase in reserve reduces by eight to twelve times the amount of net loans exposure a bank can allow itself and double that in gross exposure. One $billion in capital reserve typically supports $25 billions in business deals, in gross assets. These prudential ratios, expressed as rules, equations and principles, did not however explicitly discuss what happens if a bank’s share price collapses by $10-90 billions as we have seen across a range of banks, nor over what period of time the banks can be allowed to replenish their reserves! It is to buy this time that governments have stepped in with their SARP bailouts. The longer run regulatory implications of that are also implicit, but should perhaps now be spelled out in more precise detail. B2 was designed to minimise the need for central banks' lifeboats and to delegate much of regulators' risk audits to risk units internal to the banks to be staffed by risk experts outside of banks' regular promotion stakes who have no responsibility for profit & loss, only responsibility to uphold the law, as is true too for compliance officers.
Compliance with Basel II is essential to banking licenses in any EU state, and practically also to a bank’s internal and external cost of funding, and thereby to its credit risk grading with AA- or at worst A as the minimum required to borrow unsecured funds on the interbank market, but depending on the period (maturity) of the loan. For some two years before the credit crunch many banks in all OECD countries were on the AA- threshold, but this was considered a line below which they were unlikely to fall except in exceptional circumstances. That interbank liquidity could totally dry up in a systemic crisis was not expected in OECD countries; that was something that only happened in emerging markets during currency crises. Like any public quoted firms, big banks are very attuned to their quarterly and annual accounts reporting. Without being derogatory to all, the plain truth is that all firms are attuned to gaming the end of accounting period results and less attuned to monitoring how volatile the balances can be between reporting deadlines. Yet, this is at the heart of what banks did wrong? They “bet the bank” by using too much temporary leverage, sweating assets and liabilities to the maximum, meaning the bank could go bust if big bets suddenly behaved far out of line with value at risk models. This is conventionally called “concentration risk”, but actually means more than that. High leverage must be safe all the time because even if they are safe long term, they may not weather a short-term shock. Ensuring safety means resorting to insurance cover, derivatives etc. and that means higher counter-party and double-default risks. But, these are only expected to be a problem in a systemic collapse. One safeguard banks hid behind was that if they were only doing what everyone else is doing, then if a systemic risk occurs it is not their fault; it is everyone’s fault. This is the classic criminal’s defence: I was only following orders; I was only doing what everyone knows everyone else is doing! Institutions should have learned from the 1998 experience of Long-Term Capital Management (LTCM) hedge fund and many other such examples from the quite recent past. That said, most bankers seemed to assume that these lessons are always learned and appropriate safeguards must, somehow or other, have been implemented in a banks’ risk systems or regulators’ rules. On the face of it there was a misconstruing of what ‘own capital’ reserves are and confusing this with deposits. While banks, with stable deposits bases, leveraged between 10:1 and 12:1, very high when aggregate risk-adjusted collateral was usually only 50%. Lehmans and Bear Stearns (typically for investment banks and hedge funds) had leverage ratios of more than 30:1—and that was only balance sheet assets. Their actual leverage including off balance sheet risks was much higher. In other words, these banks had evolved into highly leveraged hedge funds, and experienced a fate similar to LTCM ten years earlier – lessons were not learned.
Commercial banks and investment banks failed to effectively diversify risks, placing too many eggs in a few highly correlated baskets (such as residential and commercial real estate). The only defence here is that real estate is a ubiquitous collateral, appearing everywhere hard-wired like risk grade ratings directly and indirectly hidden in banks' balance sheets. Consequently, banks had great difficulty across all their business lines and asset classes of knowing what their exposure to property in total actually was. It therefore, does little good to say banks simply believed residential property would always rise in value when this was the universal collateral of the whole economy. Ultimately, banks did not examine the diversity of asset classes in all collateral, but instead focused on published risk gradings. Here again these were misunderstood. Risk grades are through-the-cycle values observed over large populations of borrowers by type. They are not generally adjusted for short term changes in economic circumstances. That was left to the lenders to do and they neglected this just as they generally neglected economic forecasting.
General problems are difficult to quantify when evaluating risks; banks for example do not assess the risks they themselves pose to their counter-parties, clients and customers, or to the economy as a whole, notwithstanding that central banks do and issued many warnings over the years, warnings that again the banks mostly ignored. From a borrower’s point of view the bank is the most insecure creditor because the bank can deem a loan contract at any time without notice. Similarly, banks borrowings from each other including collateral and call-margins they pledge in return are always at risk of being deemed or liquidated at any time with little or no notice! A huge amount of risk was assumed as being mitigated by the regularity and dependability of interbank liquidity. Regulators and banks were still grappling with how to transform the principles of managing liquidity risk into detailed analyses when the credit crunch crisis erupted. They forgot that even if assets have low risk correlations, those risks may turn high very suddenly at the wrong time. But, this was deemed under the regulations as a 1 in 25 year event. What urgency is applied to a 1 in 25 risk is precisely where moral hazard resides. It is said that bankers treated the prospect of house prices falling sharply as impossible or sub-prime borrowers as being unlikely to default. Neither claim is true. The banks merely preferred to assume that such problems are more likely to be over the horizon than precisely this year or next. Sub-prime borrowers are not more risky that the regular allowance for such risk; they become extremely risky only when there is a recession and sudden high unemployment. Governments had paid lip service to the idea that boom and bust could be massaged out of modern economies, and they also encouraged mortgages for the poor as a social good, (saving governments the cost of spending on social housing).
Some commentators say that banks failed to understand that liquidity can be illusory. This is true. Liquidity cannot be measured by primary markets, only in secondary markets. There were many buyers for mortgage-backed bonds when first issued but that does not prove the market is liquid. This is only proved when the bonds are successfully resold without buyers worrying that if they’re so good (triple-A) why are they being sold on? Investors in senior (protected) tranches of mortgage backed bonds were buying the rating not the underlying. Triple-A rated bonds were deemed to be as good as government bonds and could be easily pledged as collateral for 80-% or more of their face value. The situation became critical when banks also sold the high risk equity (basement) tranches and the bonds became effectively divorced, except by management contract, from the underlying assets. Buyers were trusting and naïve and the banks were cynical and foolish.
Investment banks and active managers (including hedge funds) cannot protect investors from bear markets, but this is what investors demanded and the basis upon which many $billions are being demanded in reparations in the law courts!