What should count as bank capital?

My last post looked at a RBNZ consultation paper which addressed the question “How much capital is enough?”. The overall quantum of capital the RBNZ arrived at (16% of RWA plus) seemed reasonable but it was less obvious that relying almost entirely on CET1 was the right solution. That prompted me to revisit an earlier consultation paper in which the RBNZ set out its case for why it did not want contingent capital instruments to play a significant role in the capital structure of the banks it supervises. This post explores the arguments the RBNZ marshals to support its position as part of a broader exploration of the debate over what counts as capital.

The traditional approach to this question assumes that common equity is unquestionably the best form of capital from the perspective of loss absorption. Consequently, the extent to which alternative forms of funding count as capital is judged by common equity benchmarks; e.g. the extent to which the funding is a permanent commitment (i.e. no maturity date) and the returns paid to investors depend on the profitability or capacity of the company to pay (failure to pay is not an event of default).

There is no dispute that tangible common equity unquestionably absorbs loss and is the foundation of any company’s capital structure but I believe contingent convertible capital instruments do potentially add something useful to the bank capital management toolkit. I will attempt to make the case that a foundation of common equity, supplemented with some debt that converts to common equity if required, is better than a capital structure comprised solely or largely of common equity.

The essence of my argument is that there is a point in the capital structure where adding contingent convertible instruments enhances market discipline relative to just adding more common equity. The RBNZ discusses the potential value of these structures in their consultation paper:

49. The theoretical literature on contingent debt explores how these instruments might reduce risk (i.e. lower the probability of insolvency) for an individual bank.  

50. Two effects have been identified. Firstly, adding contingent debt to a bank’s balance sheet directly increases the loss absorbing potential of the bank, relative to issuing pure debt (but not relative to acquiring more common equity). This follows directly from the fact that removing the debt is an essential part of every contingent debt instrument. Secondly, depending on the terms, contingent capital may cause bank management to target a lower level of risk (incentive effects). In other words, in theory, a contingent debt instrument both reduces the probability a bank will incur losses and absorbs losses that do eventuate. Because of both these factors, contingent debt is expected, in theory, to reduce the risk of bank failure.  

51. Focusing on the second of these effects, management incentives, it matters whether, when the debt is written off, holders are compensated in the form of newly issued shares (“conversion”). If conversion is on such a scale as to threaten existing shareholders with a loss of control of the bank, it will be optimal for bank management to target a lower level of risk exposure for a given set of circumstances than would have been the case otherwise. For example, bank management may be less tolerant of asset volatility, and more likely to issue new equity to existing shareholders, when capital is low rather than risk triggering conversion.”

RBNZ Capital Review Paper 2: What should qualify as bank capital? Issues and Options (para 49 – 51) – Emphasis added

So the RBNZ does recognise the potential value of contingent debt instruments but chose to downplay the benefits while placing much greater weight on a series of concerns it identified.

What’s in a name – The RBNZ Taxonomy of Capital

Before digging into the detail of the RBNZ concerns, it will be helpful to first clarify terminology. I am using the term Contingent Convertible Instruments for my preferred form of supplementary capital whereas much of the RBNZ paper focuses on what it refers to as “Contingent debt instruments“, which it defines in part as “debt that absorbs loss via write-off, which may or may not be followed by conversion”.

I had not picked this up on my first read of the RBNZ paper but came to realise we are talking slightly at cross purposes. The key words to note are “contingent” and “convertible”.

  • The “contingent” part of these instruments is non-negotiable if they are to be accepted as bank regulatory capital. The contingency is either a “non-viability event” (e.g. the supervisor determines that the bank must increase common equity to remain viable) or a CET1 ratio of 5.125% or less (what APRA terms a “loss absorption trigger” and the RBNZ refers to as a “going-concern trigger”)
  • “Conversion” however is optional. Loss absorption is non-negotiable for bank regulatory capital but it can be achieved in two ways. I have argued that loss absorption is best achieved by converting these capital instruments into common equity but prudential regulation is satisfied so long as the instruments are written-off.

I had taken it as given that these instruments would be convertible but the RBNZ places more emphasis on the possibility that conversion “may or may not” follow write-off. Small point but worth noting when evaluating the arguments.

Why does conversion matter?

The RBNZ understandably focuses on the write-off part of the loss absorption process whereas I focus on conversion because it is essential to preserving a loss hierarchy that allocates losses to common equity in the first instance. If we ignore for a moment the impact of bail-in (either by conversion or write-off), the order in which losses are applied to the various sources of funding employed by a bank follows this loss hierarchy:

  • Going Concern:
    • Common Equity Tier 1 (CET1)
    • Additional Tier 1 (AT1)
  • Insolvency – Liquidation or restructuring:
    • Tier 2 (T2)
    • Senior unsecured
    • Super senior
      • Covered bonds
      • Deposits
      • Insured deposits

Under bail-in, writing off a contingent capital instrument generates an increase in common equity that accrues to the existing ordinary shareholders thereby negating the traditional loss hierarchy that requires common equity to be exhausted before more senior instruments can be required to absorb loss.

Conversion is a far better way to effect loss absorption because ordinary shareholders still bear the brunt of any loss, albeit indirectly via the dilution of their shareholding (and associated share price losses). In theory, conversion shields the AT1 investors from loss absorption because they receive common equity equivalent in value to the book value of their claim on the issuer. In practice, it is less clear that the AT1 investors will be able to sell the shares received at the conversion price or better but they are still better off than if they had simply seen the value of their investment written-off. If you are interested in digging deeper, this post looks at how loss absorption works under bail-in.

The RBNZ does recognise this dynamic but still chose to reject these advantages so it is time to look at their concerns.

RBNZ concerns with contingent capital

The RBNZ identified six concerns to justify its in principle decision to exclude the use of contingent capital instruments in the NZ capital adequacy framework.

  1. Possible under-estimation of the tax effects of contingent debt
  2. Reliance on parent entities as purchasers of AT1 contingent debt
  3. Not suitable for retail investors
  4. Banks structured as mutual societies cannot offer contingent debt that includes conversion into common equity
  5. Potential for regulatory arbitrage arising from the tension between tax and capital regulation
  6. Difficulties with exercising regulatory oversight of contingent debt

I don’t imagine the RBNZ is much concerned with my opinion but I don’t find the first three concerns to be compelling. I set out my reasons later in the post but will focus for the moment on three issues that I think do bear deeper consideration. You do not necessarily have to agree with the RBNZ assessment, or the weight they assign to them, but I believe these concerns must be addressed if we are to make the case for contingent debt.

Stronger arguments against contingent debt

1) Contingent debt gives the larger, listed banks a competitive advantage over mutual societies that are unable to issue ordinary shares

The RBNZ notes that all New Zealand banks are able to issue a version of contingent debt that qualifies as capital, but that some types of banks may have access to a broader – and cheaper – range of capital opportunities than others. The current definition of capital is thus in part responsible for a somewhat uneven playing field.

The primary concern seems to be banks structured as mutual societies which are unable to issue ordinary shares. They cannot offer contingent debt that includes conversion and must rely on the relatively more expensive option of writing-off of the debt to effect loss absorption.

I think this is a reasonable concern but I also believe there may be ways to deal with it. One option is for these banks to issue Mutual Equity Interests as has been proposed in Australia. Another option (also based on an Australian proposal) is that the increased requirements for loss absorbing capital be confined to the banks which cannot credibly be allowed to fail or be resolved in any other way. I recognise the this option benefits from the existence of deposit insurance which NZ has thus far rejected.

I need to do bit more research on this topic so I plan to revisit the way we deal with small banks, and mutuals in particular, in a future post.

2) Economic welfare losses due to regulatory arbitrage opportunities in the context of contingent debt

The tax treatment of payments to security holders is one of the basic tests for determining if the security is debt or equity but contingent debt instruments don’t fall neatly into either box. The conversion terms tied to PONV triggers make the instruments equity like when the issuer is under financial stress while the contractual nature of the payments to security holders makes them appear more debt like under normal operating conditions.

I can see a valid prudential concern but only to the extent the debt like features the tax authority relied on in making its determination regarding tax-deductibility somehow undermined the ability of the instrument to absorb loss when required.

There have been instances where securities have been mis-sold to unsophisticated investors (the Monte dei Paschi di Sienna example cited by the RBNZ is a case in point) but it is less obvious that retail investment by itself is sufficient cause to rule out this form of capital.

The only real difference I see over conventional forms of debt is the line where their equity like features come into play. Conventional debt is only ever at risk of loss absorption in the event of bankruptcy where its seniority in the loss hierarchy will determine the extent to which the debt is repaid in full. These new forms of bank capital bring forward the point at which a bank balance sheet can be restructured to address the risk that the restructuring undermines confidence in the bank. The economics of the restructuring are analogous so long as losses are allocated by conversion rather than by write-off alone.

3) Difficulties experienced with the regulatory oversight of contingent debt

Possibly their core concern is that overseeing instrument compliance is a complex and resource-intensive process that the RBNZ believes does not fit well with its regulatory model that emphasises self-discipline and market discipline. The RBNZ highlights two concerns in particular.

  • Firstly the RBNZ has chosen to respond to the challenge of vetting these instruments by instituting a “non-objection process” that places the onus on issuers to confirm that their instruments comply with the capital adequacy requirements.
  • Secondly, notwithstanding the non objection process, the added complexity of the instruments relative to common equity, still requires significant call on prudential resources.

This I think, is the strongest objection the RBNZ raises against contingent debt. Contingent debt securities are clearly more complex than common equity so the RBNZ quite reasonably argues that they need to bring something extra to the table to justify the time, effort and risk associated with them. There is virtually no justification for them if they do, as the RBNZ asserts, work against the principles of self and market discipline that underpin its regulatory philosophy.

Three not so compelling reasons for restricting the use of contingent capital instruments (“in my humble opinion’)

1) Possible under-estimation of the tax effects of contingent debt

The first concern relates to the RBNZ requirement that banks must acknowledge any potential tax implications arising from contingent debt and reflect these potential “tax offsets” in the reported value of capital. Banks are required to obtain a binding ruling from the NZ tax authority (or voluntarily take a tax ”haircut”). The RBNZ acknowledges that a binding ruling can provide comfort that tax is fully accounted for under prudential requirements, but quite reasonably argues that this will only be the case if the ruling that is sought is appropriately specified so as to capture all relevant circumstances.

The RBNZ’s specific concern seems to be what happens when no shares are issued in the event of the contingent loss absorption feature being triggered and hence no consideration is paid to investors in exchange for writing off their debt claim. The bank has made a gain that in principle would create a tax lability but it also seems reasonable to assume that the write off could only occur if the bank was incurring material losses. It follows then that the contingent tax liability created by the write off is highly likely to be set off against the tax losses such that there is no tax to pay.

I am not a tax expert so I may well be missing something but I can’t see a practical risk here. Even in the seemingly unlikely event that there is a tax payment, the money represents a windfall gain for the public purse. That said, I recognise that the reader must still accept my argument regarding the value of having the conversion option to consider it worth dealing with the added complexity.

2) A reliance on parent entities as purchasers of AT1 contingent debt

I and the RBNZ both agree that one of the key planks in the case for accepting contingent debt as bank capital is the beneficial impact on bank risk taking but the RBNZ argues this beneficial impact is less than it could be when the instrument is issued by a NZ subsidiary to its publicly listed parent.

I may be missing something here but the parent is exposed to dilution if the Non-Viability or Going Concern triggers are hit so I can’t see how that reduces the incentive to control risk unless the suggestion is that NZ management will somehow have the freedom to pursue risky business strategies with no input from their ultimate owners.

3) Retail investors have acquired contingent debt

The RBNZ cites some statistical evidence that suggests that, in contrast to the experience overseas, there appears to be limited uptake by wholesale investors of contingent debt issued by the big four banks. This prompts them to question whether the terms being offered on instruments issued outside the parent group are not sufficiently attractive for sophisticated investors. This concern seems to be predicated on the view that retail will always be the least sophisticated investors so banks will seek to take advantage of their relative lack of knowledge.

It is arguably true that retail investors will tend be less sophisticated than wholesale investors but that should not in itself lead to the conclusion that any issue targeted at retail is a cynical attempt at exploitation or that retail might legitimately value something differently to the way other investors do. The extent that the structures issued by the Australian parents have thus far concentrated on retail, for example, might equally be explained by the payment of franking credit that was more highly valued by the retail segment. Offshore institutions might also have been negative on the Australian market therefore pushing Australian banks to focus their efforts in the domestic market.

I retain an open mind on this question and need to dig a bit deeper but I don’t see how the fact that retail investment dominates the demand for these structures at a point in time can be construed to be proof that they are being mis-sold.

The RBNZ’s answer ultimately lies in their regulatory philosophy

The reason that the RBNZ rejects the use of these forms of supplementary capital ultimately appears to lie in its regulatory philosophy which is based on the following principles

  • Self discipline on the part of the financial institutions they supervise
  • Market discipline
  • Deliberately conservative
  • Simplicity

The RBNZ also acknowledges the value of adopting BCBS consistent standards but this is not a guiding principle. It reserves the right to adapt them to local needs and, in particular, to be more conservative. It should also be noted that the RBNZ has quite deliberately rejected adopting deposit insurance on the grounds (as I understand it) that this encourages moral hazard. They take this a step further by foregoing any depositor preference in the loss hierarchy and by a unique policy of Open Bank Resolution (OBR) under which deposits are explicitly included in the liabilities which can be written down in need to assist in the recapitalisation of an insolvent bank.

In theory, the RBNZ might have embraced contingent convertible instruments on the basis of their consistency with the principles of self and market discipline. The threat of dilution via conversion of the instrument into common equity creates powerful incentives not just for management to limit excessive risk taking but also for the investors to exert market discipline where they perceive that management is not exercising self-discipline.

In practice, the RBNZ seems to have discounted this benefit on the grounds that that there is too much risk, either by design or by some operational failure, that these instruments might not convert to common equity. They also seem quite concerned with structures that eschew conversion (i.e. loss absorption effected by write-off alone) but they could have just excluded these instruments rather than a blanket ban. Having largely discounted or disregarded the potential benefit, the principles of deliberate conservatism and simplicity dictate their proposed policy position, common equity rules.

Summing up

This post only scratches the surface of this topic. My key point is that contingent convertible capital instruments potentially add something useful to the bank capital management toolkit compared to relying entirely on common equity. The RBNZ acknowledge the potential upside but ultimately argue that the concerns they identify outweigh the potential benefits. I have reviewed their six concerns in this post but need to do a bit more work to gain comfort that I am not missing something and that my belief in the value of bail-in based capital instruments is justified.

Tony

How much capital is enough? – The NZ perspective

The RBNZ has delivered the 4th instalment in a Capital Review process that was initiated in March 2017 and has a way to run yet. The latest consultation paper addresses the question “How much capital is enough?”.  The banking industry has until 29 March 2019 to respond with their views but the RBNZ proposed answer is:

  • A Tier 1 capital requirement of 16% of RWA for systemically important banks and 15% of RWA for all other banks
  • The Tier 1 minimum requirement to remain unchanged at 6% (with AT1 capital continuing to be eligible to contribute a maximum of 1.5 percentage points)
  • The proposed increased capital requirement to be implemented via an overall prudential capital buffer of 9-10% of RWA comprised entirely of CET1 capital;
    • Capital Conservation Buffer 7.5% (currently 2.5%)
    • D-SIB Buffer 1.0% (no change)
    • Counter-cyclical buffer 1.5% (currently 0%)

The increase in the capital ratio requirement is proposed to be supplemented with a series of initiatives that will increase the RWA of IRB banks:

  • The RBNZ proposes to 1) remove the option to apply IRB RW to sovereign and bank exposures,  2) increase the IRB scalar (from 1.06 to 1.20) and 3) to introduce an output floor set at 85% of the Standardised RWA on an aggregate portfolio basis
  • As at March 2018, RWA’s produced by the IRB approach averaged 76% of the Standardised Approach and the RBNZ estimate that the overall impact will be to increase the aggregate RWA to 90% of the outcome generated by the Standardised approach (i.e. the IRB changes, not the output floor, drive the increase in RWA)
  • Aggregate RWA across the four IRB banks therefore increases by approximately 16%, or $39bn, compared to March 2018 but the exact impact will depend on how IRB banks respond to the higher capital requirements

The RBNZ has also posed the question whether a Tier 2 capital requirement continues to be relevant given the substantial increase in Tier 1 capital.

Some preliminary thoughts …

There is a lot to unpack in this paper so this post will only scratch the surface of the issues it raises …

  • The overall number that the RBNZ proposes (16%) is not surprising.It looks to be at the lower end of what other prudential regulators are proposing in nominal terms
    • But is in the same ball park once you allow for the substantial increase in IRB RWA and the fact that it is pretty much entirely CET1 capital
  • What is really interesting is the fundamentally different approach that the RBNZ has adopted to Tier 2 capital and bail-in versus what APRA (and arguably the rest of the world) has adopted
    • The RBNZ proposal that the increased capital requirement take the form of CET1 capital reflects its belief that “contingent convertible instruments” should be excluded from what counts as capital
    • Exactly why the RBNZ has adopted this position is a complex post in itself (their paper on the topic can be found here) but the short version (as I understand it) is that they think bail-in capital instruments triggered by non-viability are too complex and probably won’t work anyway.
    • Their suggestion that Tier 2 probably does not have a role in the capital structure they have proposed is logical if you accept their premise that Point of Non-Viability (PONV) triggers and bail-in do not work.
  • The RBNZ highlight a significantly enhanced role for prudential capital buffersI am generally in favour of bigger, more dynamic, capital buffers rather than higher fixed minimum requirements and I have argued previously in favour of the base rate for the counter-cyclical being a positive value (the RBNZ propose 1.5%)
    • But the overall size of the total CET1 capital buffer requirement requires some more considered thought about 1) the role of bail-in  structures and PONV triggers in the capital regulation toolkit (as noted above) and 2) whether the impacts of the higher common equity requirement will be as benign as the RBNZ analysis suggests
  • I am also not sure that the indicative capital conservation responses they have outlined (i.e. discretionary distributions limited to 60% of net earnings in the first 250bp of the buffer, falling to 30% in the next 250bp and no distributions thereafter) make sense in practice.
    • This is because I doubt there will be any net earnings to distribute if losses are sufficient to reduce CET1 capital by 250bp so the increasing capital conservation requirement is irrelevant.
  • Last, but possibly most importantly, we need to consider the impact on the Australian parents of the NZ D-SIB banks and how APRA responds. The increase in CET1 capital proposed for the NZ subsidiaries implies that, for any given amount of CET1 capital held by the Level 2 Banking Group, the increased strength of the NZ subsidiaries will be achieved at the expense of the Australian banking entities
    • Note however that the impact of the higher capital requirement in NZ will tend to be masked by the technicalities of how bank capital ratios are calculated.
      • It probably won’t impact the Level 2 capital ratios at all since these are a consolidated view of the combined banking group operations of the Group as a whole
      • The Level 1 capital ratios for the Australian banks also treat investments in bank subsidiaries relatively generously (capital invested in unlisted subsidiaries is treated as a 400% risk weighted asset rather than a capital deduction).

Conclusion

Overall, I believe that the RBNZ is well within its rights to expect the banks it supervisors to maintain a total level of loss absorbing capital of 16% or more. The enhanced role for capital buffers is also a welcome move.

The issue is whether relying almost entirely on CET1 capital is the right way to achieve this objective. This is however an issue that has been debated for many decades with no clear resolution. It will take some time to fully unpack the RBNZ argument and figure out how best to articulate why I disagree. In the interim, any feedback on the issues I have outlined above would be most welcome.

Tony

Revisiting the mortgage risk weight fact check

The ACCC’s Final Report on its “Residential Mortgage Price Inquiry” (Section 4.3) listed four challenges faced by the smaller banks in making decisions about their residential mortgage product offering; specifically 1) APRA’s prudential benchmarks, 2) APRA’s regulatory capital requirements, 3) service levels to brokers and aggregators, and 4) customer loyalty to the big four banks and customer inertia.

The smaller banks undoubtedly face a number of challenges in competing with the bigger banks but I have argued previously that the difference in regulatory capital requirements is overstated.

The ACCC describe the challenge with APRA’s regulatory capital requirements as follows:

For otherwise identical ADIs, the advantage of a 25% average risk weight (APRA’s minimum for IRB banks) compared to the 39% average risk weight of standardised ADIs is a reduction of approximately 0.14 percentage points in the cost of funding the loan portfolio. This difference translates into an annual funding cost advantage of almost $750 on a residential mortgage of $500 000, or about $15 000 over the 30 year life of a residential mortgage (assuming an average interest rate of 7% over that period).

The report does offer some caveats on the size of the difference in risk weights …

This estimate is indicative only. No allowance has been made for the cost to IRB-accredited ADIs of achieving or maintaining their IRB accreditation, or for other differences between IRB and standardised ADIs in funding their residential mortgage portfolios, such as differences in wholesale funding costs and other aspects of APRA’s capital adequacy regime which impose additional capital costs on IRB-accredited banks.

But the commentary I read in the financial press just focussed on the nominal difference in the risk weights (i.e. 25% versus 39%) without any of the qualifications. My early post on this question identified 5 problems with the simplistic comparison cited by the ACCC:

  • Problem 1 – Capital adequacy ratios differ
  • Problem 2 – You have to include capital deductions
  • Problem 3 – The standardised risk weights for residential mortgages seems set to change
  • Problem 4 – The risk of a mortgage depends on the portfolio not the individual loan
  • Problem 5 – You have to include the capital required for Interest Rate Risk in the Banking Book? 

Summing up

My aim in this and the original post was not to defend the big banks but rather to try to contribute some of the knowledge I have acquired working in this area to what I think is an important but misunderstood question. In the interests of full disclosure, I have worked for one of the large Australian banks and may continue to do work for them in the future.

On a pure risk basis, it seems to me that the loan portfolio of a large bank will tend to be more diversified, and hence lower risk, than that of a smaller bank. It is not a “gift” for risk weights to reflect this.

There is a legitimate debate to be had regarding whether small banks should be given (gifted?) an advantage that helps them compete against the big banks. That debate however should start with a proper understanding of the facts about how much advantage the large banks really have and the extent to which their lower risk weights reflect lower risk.

If you disagree tell me what I am missing …

Loss absorption under bail-in

I recently did a post on a Discussion Paper setting out how APRA proposes to increase the Loss Absorption Capital (LAC) of Australian authorised deposit-taking institutions (ADIs). I came down on the side of this being a desirable (arguably necessary) enhancement of the Australian financial system but noted that the devil was in the detail. One of the issues discussed was the potential impact of the proposal on the statutory and contractual loss hierarchy that defines the sequence in which losses are absorbed by the capital of the bank in the first instance, and by more senior sources of funding in need.  

This post attempts to dig a bit deeper into this question to better understand how losses would be assigned under a bail-in scenario. It is a pretty technical point and possibly of limited interest but I wanted to make sure I had a good handle on how loss absorption plays out in the future. Read on or stop here.

Key points

  • The bail-in of selected, pre-positioned liabilities modifies the traditional loss hierarchy that applies in a liquidation scenario 
    • As a general rule, the absorption of losses is accelerated across all tiers of LAC
    • CET1 investors bear the loss via the dilution of their shareholdings as AT1 and Tier 2 are converted to common equity
    • AT1 investors risk not receiving distributions but otherwise the loss hierarchy between them and T2 investors seems to collapse once their holdings are converted into CET1
    • The only potential advantage to Tier 2 in these scenarios is that these instruments may only face partial conversion but how beneficial depends on the extent to which conversion to common equity offers a better chance to liquidate their holding versus selling the Tier 2 instrument itself into what is likely to be a very illiquid market
  • This has been increasingly true since APRA introduced Point of Non-Viability (PONV) conversion triggers in 2013, and the instruments without this contractual feature progressively matured, but the proposed expansion of the pool of LAC takes us further down this path:
    • partly by virtue of making it easier for APRA to restructure bank capital structures without recourse to taxpayer support (i.e. the odds of bail-in being used in a future crisis are increased if the tool itself is more effective); and
    • partly by increasing the quantum of CET1 dilution that is the mechanism by which losses are allocated to the various tiers of LAC
  • Investors in the various capital tiers will obviously adjust the return they require for the risks they are asked to bear but we should ensure we all have a clear and consistent understanding of how the loss hierarchy is modified, and whether the resulting loss hierarchy is desirable (or indeed equitable)
  • The answer to this question turns in part on whether the outcomes for AT1 and T2 investors are better or worse than the market value they could achieve if they sold their investments prior to bail-in 

Loss Hierarchy – the simple version

Prudential Standard APS 111 (Capital Adequacy: Measurement of Capital) defines the order of seniority amongst the three tiers of prudential capital:

  • CET1 Capital “… rank behind the claims of depositors and other more senior creditors in the event of a winding up of the issuer ” (Para 19 (d))
  • AT1 Capital “… rank behind the claims of depositors and other more senior creditors in the event of a winding up of the issuer” (Para 28 (c))
  • Tier 2 Capital “represents, prior to any conversion to Common Equity Tier 1 … the most subordinated claim in liquidation of the issuer after Common Equity Tier 1 Capital instruments and Additional Tier 1 Capital instruments (Attachment H, Para 1 (b))

APS 111 (Attachment F, Para 10) also explicitly allows AT1 instruments to 1) differentiate as to whether the instrument is required to convert or be written-off in the first instance, and 2) provide for a ranking under which individual AT1 instruments will be converted or written-off. The guidance on Tier 2 is less explicit on this point but there does not seem to be any fundamental reason why a bank could not introduce a similar ranking within the overall level of subordination. I am not aware of any issuer using this feature for either AT1 or T2.

If we ignore for a moment the impact of bail-in (either by conversion or write-off), the order in which losses are applied to the various sources of funding employed by a company follows this loss hierarchy:

  • Going Concern:
    • Common Equity Tier 1 (CET1)
    • Additional Tier 1 (AT1)
  • Insolvency – Liquidation or restructuring:
    • Tier 2 (T2)
    • Senior unsecured
    • Super senior
      • Covered bonds
      • Deposits
      • Insured deposits

CET1 is clearly on the front line of loss absorption (a perpetual commitment of funding with any returns subject to the issuer having profits to distribute and the Capital Conservation Ratio (CCR) not being a constraint). AT1 is subject to similar restrictions, though its relative seniority does offer some protection regarding the payment of regular distributions.

Traditionally, the claims the other forms of funding have on the issuer are only at risk in the event of the liquidation or restructuring of the company but bail-in modifies this traditional loss hierarchy.

What happens to the loss hierarchy under bail in?

First up, let’s define bail-in …

A bail-in is the rescue of a financial institution that is on the brink of failure whereby creditors and depositors take a loss on their holdings. A bail-in is the opposite of a bailout, which involves the rescue of a financial institution by external parties, typically governments that use taxpayers money.” (Investopedia)

Investopedia’s definition above is useful, albeit somewhat generic. Never say never, but the loss hierarchy employed in Australia, combined with the fact that there are substantial layers of more junior creditors for big banks in particular, means that most Australian depositors (even the ones that do not have the benefit of deposit insurance) are pretty well insulated from bail-in risk. Not everyone would share my sanguine view on this question (i.e. the limited extent to which deposits might be bailed in) and some countries (NZ for example) quite explicitly choose to forego deposit insurance and move deposits up the loss hierarchy by ranking them equally with senior unsecured creditors.

The main point of bail-in is that existing funding is used to recapitalise the bank, as opposed to relying on an injection of new capital from outside which may or may not be forthcoming. It follows that pre-positioning sufficient layers of loss absorption, and making sure that investors understand what they have signed up for, is critical.

AT1 has always been exposed to the risk of its distributions being cut. This sounds good in theory for loss absorption but the size of these potential capital outflows is relatively immaterial in any real stress scenario. It could be argued that every dollar helps but my view is that the complexity and uncertainty introduced by making these distributions subject to the Capital Conservation Ratio (CCR) outweigh any contribution they might make to recapitalising the bank. The people who best understand this point are those who have had to calculate the CCR in a stress scenario (you have to get into the detail to understand it). The CCR issue could be addressed by simplifying the way it is calculated and I would argue that simplicity is always a desirable feature of any calculation that has to be employed under conditions of stress and uncertainty. The main point however is that it does very little to help recapitalise the bank because the heavy lifting in any really severe stress scenario depends on the capacity to convert a pool of pre-positioned, contingent capital into CET1.

APRA has had explicit power to bail-in AT1 and T2 since the January 2013 version of APS 111 introduced Point of Non-Viability (PONV) conversion triggers – these enhanced powers do a few things:

  • The impact of losses is brought forward relative what would apply in a conventional liquidation or restructuring process
  • For CET1 investors, this accelerated impact is delivered via the dilution of their shareholdings (and associated share price losses)
  • In theory, conversion shields the AT1 investors from loss absorption because they receive common equity equivalent in value to the book value of their claim on the issuer
  • In practice, it is less clear that the AT1 investors will be able to sell the shares at the conversion price or better, especially if market liquidity is adversely impacted by the events that called the viability of the issuer into question
  • The conversion challenge will be even greater to the extent that T2 investors are also bailed-in and seek to sell the shares they receive

Tier 2 will only be bailed-in after AT1 bail-in has been exhausted, as would be expected given its seniority in the loss hierarchy, but it is hard to see a bail-in scenario playing out where the conversion of AT1 alone is sufficient to restore the viability of the bank. AT1 is likely to represent not much more than the 1.5 percentage points of RWA required to meet minimum requirements but any crisis sufficient to threaten the viability of a bank is likely to require a much larger recapitalisation so full or partial conversion of T2 should be expected.

Partial conversion 

Attachment J – Para 6 provides that “Conversion or write-off need only occur to the extent necessary to enable APRA to conclude that the ADI is viable without further conversion or write-off”. Para 8 of the same attachment also specifies that “An ADI may provide for Additional Tier 1 Capital instruments to be converted or written off prior to any conversion or write-off of Tier 2 Capital instruments”.

This makes it reasonably clear that APRA will not automatically require all AT1 and Tier 2 to be converted or written-off but the basis on which partial conversion would be applied is not covered in the discussion paper. A pro-rata approach (i.e. work out how much of the aggregate Tier 2 is required to be converted and then apply this ratio to each  individual instrument) seems the simplest option and least open to legal challenge but it may be worth considering alternatives.

Converting the Tier 2 instruments closest to maturity in particular seems to offer some advantages over the pro rata approach

  • It generates more CET1 capital than the Tier 2 foregone (because the Tier 2 capital value of an instrument is amortised in its final 5 years to maturity whereas the CET1 capital created by bail-in is the full face value off the instrument)
  • It defers the need to replace maturing Tier 2 capital and maximises the residual pool of LAC post bail-in.

What is the reason for the 20% floor that APS 111 imposes on the conversion price?

The transition to a bail-in regime may be an opportune time to revisit the rationale for placing a floor on the conversion price used to convert AT1 and Tier 2 into common equity. Attachments E and F contain an identically worded paragraph 8 that requires that the share price used to calculate the shares received on conversion cannot be less than 20% of the ordinary share price at the the time the LAC instrument was issued. This floor arguably requires the share price to fall a long way before it has any effect but it is not clear what purpose is served by placing any limit on the extent to which common equity shareholders might see their holdings diluted in a non-viability scenario.

Bail-in via write-off of AT1 or T2

I am concentrating on bail-in via conversion because that seems to be the default loss absorption contemplated by APS 111 and the one that is most consistent with the traditional loss hierarchy. LAC instruments can be designed with write-off as the primary loss absorption mechanism but it is not clear that any issuer would ever choose to go down that path as it would likely be more expensive versus bail-in via conversion. The write-off option seems to have been included as a failsafe in the event that conversion is not possible for whatever reason.

Conclusion

The loss absorption hierarchy under a bail-in based capital regime is a bit more complicated than the simple, progressive three tier hierarchy that would apply in a traditional liquidation scenario. I believe however that this added complexity is justified both by the enhanced level of financial safety and by the extent to which it addresses the advantage big banks have previously enjoyed by virtue of being Too Big To Fail.

The main concern is that AT1 and Tier 2 investors who underwrite the pre-positioning of this contingent source of new CET1 capital properly understand the risks. I must confess that I had to think it through and remain open to the possibility that I have missed something … if so tell me what I am missing.

Tony

 

Does more loss absorption and “orderly resolution” eliminate the TBTF subsidy?

The Australian Government’s 2014 Financial System Inquiry (FSI) recommended that APRA implement a framework for minimum loss-absorbing and recapitalisation capacity in line with emerging international practice, sufficient to facilitate the orderly resolution of Australian authorised deposit-taking institutions (ADIs) and minimise taxpayer support (Recommendation 3).

In early November, APRA released a discussion paper titled “Increasing the loss absorption capacity of ADIs to support orderly resolution” setting out its response to this recommendation. The paper proposes that selected Australian banks be required to hold more loss absorbing capital. Domestic Systemically Important Banks (DSIBs) are the primary target but, depending partially on how their Recovery and Resolution Planning addresses the concerns APRA has flagged, some other banks will be captured as well.

The primary objectives are to improve financial safety and stability but APRA’s assessment is that competition would also be “Marginally improved” on the basis that “requiring larger ADIs to maintain additional loss absorbency may help mitigate potential funding advantages that flow to larger ADIs“. This assessment may be shaped by the relatively modest impact (5bp) on aggregate funding costs that APRA has estimated or simple regulatory conservatism. I suspect however that APRA is under selling the extent to which the TBTF advantage would be mitigated if not completely eliminated by the added layer of loss absorption proposed. If I am correct, then this proposal would in fact, not only minimise the risk to taxpayers of future banking crises, but also represent an important step forward in placing Australian ADIs on a more level playing field.

Why does the banking system need more loss absorption capacity?

APRA offers two reasons:

  1. The critical role financial institutions play in the economy means that they cannot be allowed to fail in a disorderly manner that would have adverse systemic consequences for the economy as a whole.
  2. The government should not be placed in a position where it believes it has no option but to bail out one or more banks

The need for extra capital might seem counter-intuitive, given that ADI’s are already “unquestionably strong”, but being unquestionably strong is not just about capital, the unstated assumption is that the balance sheet and business model are also sound. The examples that APRA has used to calibrate the degree of total loss absorption capacity could be argued to reflect scenarios in which failures of management and/or regulation have resulted in losses much higher than would be expected in a well-managed banking system dealing with the normal ups and downs of the business cycle.

At the risk of over simplifying, we might think of the first layers of the capital stack (primarily CET1 capital but also Additional Tier 1) being calibrated to the needs of a “good bank” (i.e. well-managed, well-regulated) while the more senior components (Tier 2 capital) represent a reserve to absorb the risk that the good bank turns out to be a “bad bank”.

What form will this extra capital take?

APRA concludes that ADI’s should be required to hold “private resources” to cope with this contingency. I doubt that conclusion would be contentious but the issue is the form this self-insurance should take. APRA proposes that the additional loss absorption requirement be implemented via an increase in the minimum Prudential Capital Requirement (PCR) applied to the Total Capital Ratio (TCR) that Authorised Deposit-Taking Institutions (ADIs) are required to maintain under Para 23 of APS 110.

“The minimum PCRs that an ADI must maintain at all times are:
(a) a Common Equity Tier 1 Capital ratio of 4.5 per cent;
(b) a Tier 1 Capital ratio of 6.0 per cent; and
(c) a Total Capital ratio of 8.0 per cent.
APRA may determine higher PCRs for an ADI and may change an ADI’s PCRs at any time.”

APS 110 Paragraph 23

This means that banks have discretion over what form of capital they use, but APRA expect that banks will use Tier 2 capital that counts towards the Total Capital Ratio as the lowest cost way to meet the requirement. Advocates of the capital structure irrelevance thesis would likely take issue with this part of the proposal. I believe APRA is making the right call (broadly speaking) in supporting more Tier 2 rather than more CET1 capital, but the pros and cons of this debate are a whole post in themselves. The views of both sides are also pretty entrenched so I doubt I will contribute much to that 50 year old debate in this post.

How much extra loss absorbing capital is required?

APRA looked at three things when calibrating the size of the additional capital requirement

  • Losses experienced in past failures of systemically important banks
  • What formal requirements other jurisdictions have applied to their banks
  • The levels of total loss absorption observed being held in an international peer group (i.e. what banks choose to hold independent of prudential minimums)

Based on these inputs, APRA concluded that requiring DSIBs to maintain additional loss absorbing capital of between 4-5 percentage points of RWA would be an appropriate baseline setting to support orderly resolution outcomes. The calibration will be finalised following the conclusion of the consultation on the discussion paper but this baseline requirement looks sufficient to me based on what I learned from being involved in stress testing (for a large Australian bank).

Is more loss absorption a good idea?

The short answer, I think, is yes. The government needs a robust way to recapitalise banks which does not involve risk to the taxpayer and the only real alternative is to require banks to hold more common equity.

The devil, however, is in the detail. There are a number of practical hurdles to consider in making it operational and these really need to be figured out (to the best of out ability) before the fact rather than being made up on the fly under crisis conditions.  The proposal also indirectly raises some conceptual issues with capital structure that are worth understanding.

How would it work in practice?

The discussion paper sets out “A hypothetical outcome from resolution action” to explain how an orderly resolution could play out.

“The approximate capital levels the D-SIBs would be expected to maintain following an increase to Total Capital requirements, and a potential outcome following the use of the additional loss absorbency in resolution, are presented in Figure 6. Ultimately, the outcome would depend on the extent of losses.

If the stress event involved losses consistent with the largest of the FSB study (see Figure 2), AT1 and Tier 2 capital instruments would be converted to ordinary shares or written off. After losses have been considered, the remaining capital position would be wholly comprised of CET1 capital. This conversion mechanism is designed to allow for the ADI to be stabilised in resolution and provide scope to continue to operate, and particularly to continue to provide critical functions.”

IMG_5866.JPG

Source – APRA Discussion Paper (page 24)

What I have set out below draws from APRA’s example while adding detail that hopefully adds some clarity on what should be expected if these scenarios ever play out.

  • In a stress event, losses first impact any surplus CET1 held in excess of the Capital Conservation Buffer (CCB) requirement, and then the CCB itself (the first two layers of loss absorption in Figure 6 above)
  • As the CCB is used up, the ADI is subject to progressive constraints on discretionary distributions on CET1 and AT1 capital instruments
  • In the normal course of events, the CCB should be sufficient to cope with most stresses and the buffer is progressively rebuilt through profit retention and through new issuance, if the ADI wants to accelerate the pace of the recapitalisation process
  • The Unquestionably Strong capital established to date is designed to be sufficient to allow ADIs to withstand quite severe expected cyclical losses (as evidenced by the kinds of severe recession stress scenarios typically used to calibrate capital buffers)
  • In more extreme scenarios, however, the CCB is overwhelmed by the scale of losses and APRA starts to think about whether the ADI has reached a Point of Non-Viability (PONV) where ADI’s find themselves unable to fund themselves or to raise new equity; this is where the proposals in the Discussion Paper come into play
  • The discussion paper does not consider why such extreme events might occur but I have suggested above that one reason is that the scale of losses reflects endogenous weakness in the ADI (i.e. failures of risk management, financial control, business strategy) which compound the losses that would be a normal consequence of downturns in the business cycle
  • APRA requires that AT1 capital instruments, classified as liabilities under Australian Accounting Standards, must include a provision for conversion into ordinary shares or write off when the CET1 capital ratio falls to, or below 5.125 per cent
  • In addition, AT1 and Tier 2 capital instruments must contain a provision, triggered on the occurrence of a non-viability trigger event, to immediately convert to ordinary shares or be written off
  • APRA’s simple example show both AT1 and Tier 2 being converted to CET1 (or write-off) such that the Post Resolution capital structure is composed entirely of CET1 capital

Note that conversion of the AT1 and Tier 2 instruments does not in itself allocate losses to these instruments. The holders receive common equity equivalent to the book value of their instrument which they can sell or hold. The ordinary shareholders effectively bear the loss via the forced dilution of their shareholdings. The main risk to the ATI and Tier 2 holders is that, when they sell the ordinary shares received on conversion, they may not get the same price that which was used to convert their instrument. APRA also imposes a floor on the share price that is used for conversion which may mean that the value of ordinary shares received is less than the face value of the instrument being converted. The reason why ordinary shareholders should be protected in this way under a resolution scenario is not clear.

The devil is in the detail – A short (probably incomplete) list of issues I see with the proposal:

  1. Market capacity to supply the required quantum of additional Tier 2 capital required
  2. Conversion versus write-off
  3. The impact of conversion on the “loss hierarchy”
  4. Why not just issue more common equity?
  5. To what extent would the public sector continue to stand behind the banking system once the proposed level of self insurance is in place?

Market capacity to supply the required level of additional loss absorption

APRA has requested industry feedback on whether market appetite for Tier 2 capital will be a problem but its preliminary assessment is that:

” … individual ADIs and the industry will have the capacity to implement the changes necessary to comply with the proposals without resulting in unnecessary cost for ADIs or the broader financial system.

Preliminary estimates suggest the total funding cost impact from increasing the D-SIBs’Total Capital requirements would not be greater than five basis points in aggregate based on current spreads. Assuming the D-SIBs meet the increased requirement by increasing the issuance of Tier 2 capital instruments and reducing the issuance of senior unsecured debt, the impact is estimated by observing the relative pricing of the different instruments. The spread difference between senior unsecured debt and Tier 2 capital instruments issued by D- SIBs is around 90 to 140 basis points.”

I have no expert insights on this question beyond a gut feel that the required level of Tier 2 capital cannot be raised without impacting the current spread between Tier 2 capital and senior debt, if at all. The best (only?) commentary I have seen to date is by Chris Joye writing in the AFR (see here and here). The key points I took from his opinion pieces are:

  • The extra capital requirement translates to $60-$80 billion of extra bonds over the next four years (on top of rolling over existing maturities)
  • There is no way the major banks can achieve this volume
  • Issuing a new class of higher ranking (Tier 3) bonds is one option, though APRA also retains the option of scaling back the additional Tier 2 requirement and relying on its existing ability to bail-in senior debt

Chris Joye know a lot more about the debt markets than I do, but I don’t think relying on the ability to bail-in senior debt really works. The Discussion Paper refers to APRA’s intention that the “… proposed approach is … designed with the distinctive features of the Australian financial system in mind, recognising the role of the banking system in channelling foreign savings into the economy “ (Page 4). I may be reading too much into the tea leaves, but this could be interpreted as a reference to the desirability of designing a loss absorbing solution which does not adversely impact the senior debt rating that helps anchor the ability of the large banks to borrow foreign savings. My rationale is that the senior debt rating impacts, not only the cost of borrowing, but also the volume of money that foreign savers are willing to entrust with the Australian banking system and APRA specifically cites this factor as shaping their thinking. Although not explicitly stated, it seems to me that APRA is trying to engineer a solution in which the D-SIBs retain the capacity to raise senior funding with a “double A” rating.

Equally importantly, the creation of a new class of Tier 3 instruments seems like a very workable alternative to senior bail-in that would allow the increased loss absorption target to be achieved without impacting the senior debt rating. This will be a key issue to monitor when ADI’s lodge their response to the discussion paper. It also seems likely that the incremental cost of the proposal on overall ADI borrowing costs will be higher than the 5bp that APRA included in the discussion paper. That is not a problem in itself to the extent this reflects the true cost of self insurance against the risk of failure, just something to note when considering the proposal.

Conversion versus write-off

APRA has the power to effect increased loss absorption in two ways. One is to convert the more senior elements of the capital stack into common equity but APRA also has the power to write these instruments off. Writing off AT1 and/or T2 capital, effectively represents a transfer of value from the holders of these instruments to ordinary shareholders. That is hard to reconcile with the traditional loss hierarchy that sees common equity take all first losses, with each of the more senior tranches progressively stepping up as the capacity of more junior tranches is exhausted.

Consequently I assume that the default option would always favour conversion over write-off. The only place that I can find any guidance on this question is Attachment J to APS 111 (Capital Adequacy) which states

Para 11. “Where, following a trigger event, conversion of a capital instrument:

(a)  is not capable of being undertaken;

(b)  is not irrevocable; or

(c) will not result in an immediate and unequivocal increase in Common Equity Tier 1 Capital of the ADI,

the amount of the instrument must immediately and irrevocably be written off in the accounts of the ADI and result in an unequivocal addition to Common Equity Tier 1 Capital.”

That seems to offer AT1 and Tier 2 holders comfort that they won’t be asked to take losses ahead of common shareholders but the drafting of the prudential standard could be clearer if there are other reasons why APRA believe a write-off might be the better resolution strategy. The holders need to understand the risks they are underwriting but ambiguity and uncertainty are to helpful when the banking system is in, or a risk of, a crisis.

The impact of conversion on the “loss hierarchy”

The concept of a loss hierarchy describes the sequence under which losses are first absorbed by common equity and then by Additional Tier 1 and Tier 2 capital, if the more junior elements prove insufficient. Understanding the loss hierarchy is I think fundamental to understanding capital structure in general and this proposal in particular:

  • In a traditional liquidation process, the more senior elements should only absorb loss when the junior components of the capital stack are exhausted
  • In practice, post Basel III, the more senior elements will be required to participate in recapitalising the bank even though there is still some book equity and the ADI technically solvent (though not necessarily liquid)
  • This is partly because the distributions on AT1 instruments are subject to progressively higher capital conservation restrictions as the CCB shrinks but mostly because of the potential for conversion to common equity (I will ignore the write-off option to keep things simple)

I recognise that APRA probably tried to simplify this explanation but the graphic example they used (see Figure 6 above) to explain the process shows the Capital Surplus and the CCB (both CET1 capital) sitting on top of the capital stack followed by Tier 2, Additional Tier 1 and finally the minimum CET1 capital. The figure below sets out what I think is a more logical illustration of the capital stack and loss .

IMG_2739

Losses initially impact CET1 directly by reducing net tangible assets per share. At the point of a non-viability based conversion event, the losses impact ordinary shareholders via the dilution of their shareholding. AT1 and Tier 2 holders only share in these losses to the extent that they sell the ordinary shares they receive for less than the conversion price (or if the conversion price floor results in them receiving less than the book value of their holding).

Why not just issue more common equity?

Capital irrelevancy M&M purists will no doubt roll their eyes and say surely APRA knows that the overall cost of equity is not impacted by capital structure tricks. The theory being that any saving in the cost of using lower cost instruments, will be offset by increases in the costs (or required return) of more subordinated capital instruments (including equity).

So this school argues you should just hold more CET1 and the cost of the more senior instruments will decline. The practical problem I think is that, the cost of senior debt already reflects the value of the implied support of being too big, or otherwise systemically important, to be allowed to fail. The risk that deposits might be exposed to loss is even more remote partly due to deposit insurance but, possibly more importantly, because they are deeply insulated from risk by the substantial layers of equity and junior ranking liabilities that must be exhausted before assets are insufficient to cover deposit liabilities.

To what extent would the public sector continue to stand behind the banking system once the proposed level of self insurance is in place?

Assuming the market capacity constraint question could be addressed (which I think it can), the solution that APRA has proposed seems to me to give the official family much greater options for dealing with future banking crises without having to call on the taxpayer to underwrite the risk of recapitalising failed or otherwise non-viable banks.

It does not, however, eliminate the need for liquidity support. I know some people argue that this is a distinction without a difference but I disagree. The reality is that banking systems built on mostly illiquid assets will likely face future crises of confidence where the support of the central bank will be necessary to keep the financial wheels of the economy turning.

There are alternative ways to construct a banking system. Mervyn King, for example, has advocated a version of the Chicago Plan under which all bank deposits must be 100% backed by liquid reserves that would be limited to safe assets such as government securities or reserves held with the central bank. Until we decide to go down that path, or something similar, the current system requires the central bank to be the lender of last resort. That support is extremely valuable and is another design feature that sets banks apart from other companies. It is not the same however, as bailing out a bank via a recapitalisation.

Conclusion

I have been sitting on this post for a few weeks while trying to consider the pros and cons. As always, the risk remains that I am missing something. That said, this looks to me like a necessary (and I would argue desirable) enhancement to the Australian financial system that not only underpins its safety and stability but also takes us much closer to a level playing field. Big banks will always have the advantage of sophistication, scale and efficiency that comes with size but any funding cost advantage associated with being too big to fail now looks to be priced into the cost of the additional layers of loss absorption this proposal would require them to put in place.

Tony

Will Expected Loss loan provisioning reduce pro cyclicality?

I may not always agree with everything they have to say, but there are a few people who reliably produce content and ideas worth reading, Andy Haldane is one and Claudio Borio is another (see previous posts on Haldane here and Borio here for examples of their work). So I was interested to read what Borio had  to say about the introduction of Expected Credit Loss (ECL) provisioning. ECL is one of those topic that only interests the die-hard bank capital and credit tragics but I believe it has the potential to create some problems in the real world some way down the track.

Borio’s position is that:

  • Relative to the “incurred loss” approach to credit risk that precedes it, the new standard is likely to mitigate pro cyclicality to some extent;
  • But it will not be sufficient on its own to eliminate the risk of adverse pro cyclical impacts on the real economy;
  • So there is a need to develop what he calls “capital filters” (a generic term encompassing   capital buffers and other tools that help mitigate the risk of pro cyclicality) that will work in conjunction with, and complement, the operation of the loan loss provisions in managing credit risk.

There are two ways to respond to Claudio Borio’s observations on this topic:

  1. One is to take issue with his view that Expected Credit Loss provisioning will do anything at all to mitigate pro cyclicality;
  2. The second is to focus on his conclusion that ECL provisioning by itself is not enough and that a truly resilient financial system requires an approach that complements loan provisions

Will ECL reduce the risk of pro cyclicality?

It is true that, relative to the incurred loss model, the ECL approach will allow loan loss provisions to be put in place sooner (all other things being equal). In scenarios where banks have a good handle on deteriorating economic conditions, then it does gives more freedom to increase provisions without the constraint of this being seen to be a cynical device to “smooth” profits.

The problem I see in this assessment is that the real problems with the adequacy of loan provisioning occur when banks (and markets) are surprised by the speed, severity and duration of an economic downturn. In these scenarios, the banks may well have more ECL provisions than they would otherwise have had, but they will probably still be under provisioned.

This will be accentuated to the extent that the severity of the downturn is compounded by any systematic weakness in the quality of loans originated by the banks (or other risk management failures) because bank management will probably be blind to these failures and hence slow to respond. I don’t think any form of Expected Loss can deal with this because we have moved from expected loss to the domain of uncertainty.

The solution to pro cyclicality lies in capital not expected loss

So the real issue is what to do about that. Borio argues that, ECL helps, but you really need to address the problem via what he refers to as “capital filters” (what we might label as counter cyclical capital buffers though that term is tainted by the failure of the existing system to do much of practical value thus far). On this part of his assessment, I find myself in violent agreement with him:

  • let accounting standards do what they do, don’t try to make them solve prudential problems;
  • construct a capital adequacy solution that complements the accounting based measurement of capital and profits.

Borio does not offer any detail on exactly what these capital solutions might look like, but the Bank of England and the OFSI are working on two options that I think are definitely worth considering.

In the interim, the main takeaway for me is that ECL alone is not enough on its own to address the problem of pro cyclicality and, more importantly, it is dangerous to think it can.

Tony

Modelling bank capital requirements – The Zone of Validity

Even casual students of bank capital will be familiar with the view that advanced modelling of capital requirements is a waste of time – offering no useful insights at all and indeed dangerous to the extent these “advanced” or “sophisticated” approaches create a false sense of safety that results in excessive leverage and or credit growth.

The more technical critiques of modelling focus on the fact that a capital requirement, by definition, seeks to measure the unexpected. Mervyn King (“The End of Alchemy“), for example, argues that there is a core element of what he labels “radical uncertainty” (aka Knightian uncertainty) that cannot be modelled in the probabilistic sense that underpins the advanced approaches to capital risk measurements.

“… no amount of sophisticated statistical analysis is a match for the historical experience that “stuff happens”.  At the heart of modern macroeconomics is the same illusion that uncertainty can be confined to the mathematical manipulation of known probabilities.”

There are I think substantial elements of truth in this view. The high confidence level employed in the regulatory capital requirement was intended to bring a healthy margin of safety to the measure but the idea that a model derived answer made bank insolvency a 1: 1000 year event was never very robust once you started to look at the detail.

To be fair, the architects of Basel II were well aware of the restrictive assumptions they had made (e.g. well diversified risk, portfolio invariant) expecting that both banks and regulators would make suitable allowances for the extent to which real banks did not conform to the ideal model assumptions. In practice though, these caveats tended to get lost in the enthusiasm for a seemingly precise and robust number. Disclosure and market discipline also proved much less robust controls on bank leverage than seemed logical in the 1980’s when the Efficient Market Hypothesis reigned supreme.

There is however a “zone of validity” in which I believe that models do offer useful insight and guidance. I want to focus here on the models employed in the Internal Ratings Based (IRB) approach to credit risk; the dominant risk class for many banking systems.

I encountered the term “zone of validity” in Wilmott and Orrell’s book (The Money Formula) but I am sure the idea is not new; it is also fairly intuitive

“The key then is to keep with simple models, but make sure that the model is capturing the key dynamics of the system, and only use it within its zone of validity. Models should be seen as imperfect patches, rather than as accurate representations of the complete system. Instead of attempting … a better, more complete “theory of everything”, the aim is to find models that are useful for a particular purpose, and know when they break down”.

“The Money Formula”, Wilmott and Orrell, Chapter 8

Applying the “zone of validity” filter to IRB models

The first thing to do is distinguish the different types of models employed in the IRB framework (Yes Virginia, there is not just one monolithic IRB model). One of the people I go to when I want to understand credit risk has proposed the following taxonomy of IRB models which can be ranked in terms of robustness and empirical evidence for their effectiveness.

  • Relative Risk (Rank Ordering) Models – that measure relative risk (aka rank ordering) at an obligor level – e.g. Probability of Default (PD) rating models, Exposure at Default (EAD) segmentation models, Loss Given Default (LGD) segmentation models.
  • Point in Time (Econometric) Models – that capture the relationship between external systemic (economic) drivers and point in time default rates or loss rates – e.g. point in time PD
  • Highly Extrapolated, Point in Time, Models – Essentially the same form of model as above but applied to highly stressed or rare scenarios – e.g. stress testing models targeting a 1 in 25 year or higher scenario consistent with a severe recession
  • VAR models –  which attempt to describe the entirety of the credit loss distribution and correlation effects, usually with the goal to quantify the size of low probability tail loss events such as a 1 in 100 or 1 in 1000 year loss – e.g. capital models

Relative Risk models arguably have the widest zone of validity. We may not be able to predict precisely when individual exposures will default but models tend to do a pretty reasonable job of rank ordering the risk of default. We also have a pretty good handle on the kinds of factors that increase the severity of loss in the event of default, at least in relative terms.

From there on, the zone of validity progressively shrinks along with the degree of precision that the models are capable of offering. That said, the models can still offer useful insights so long as we understand the limitations of what they are saying.

  • Point in time models will help anchor loan loss provisioning; like any model, there will be a degree of error, but the structured approach makes it much easier to deconstruct the overall loan loss estimate and figure out where you agree or disagree with the output.
  • Highly extrapolated models such as you might see in a stress testing model clearly expand the range of error but again they offer a way of peering under the hood and seeing what part of the output looks wrong;
  • VAR models arguably do operate outside their zone of validity (at a minimum they are not a reliable measure of the 1 in 1000  year risk the bank’s capital will be sufficient) so the answers they provide need to be used with that weakness in mind.

The fixes and the potential unintended consequences

A very common response to the modelling problems discussed above is to apply more conservative values to the risk parameters (i.e PD, LGD, EAD and Correlation) employed in the IRB capital calculation. This is relatively easy to do, feels intuitively right and gives a higher capital requirement but this approach also has costs. The cost may be justified but should be recognised.

One of the issues with arbitrarily increasing risk estimates is that you start to distort the model outputs that do lie within their zone of validity. Modelling (estimating) Regulatory Expected Loss (REL), in particular, should be quite simple – just multiply PD by LGD by EAD and “voila”, we have a 1 year measure of what we expect the credit portfolio to lose at this point in the credit cycle. In principle, we can also be reasonably confident that our stressed loss estimate is useful provided we are honest about the quality of our credit portfolio and don’t get too ambitious on the level of severity. It seems to me that these applications are mostly within the zone of validity of the models we use to measure these things; and we hold capital to cover the risk that something unexpected happens.

However, we start the REL estimate by using a “downturn” measure of LGD that reflects what we expect to lose during a part of the credit cycle that may or may not coincide with where we actually are at this point in time. Next we increase PD to be conservative; again that conservative measure may or may not reflect were we actually are in the credit cycle at this point in time. The same goes for EAD. Exactly what we are measuring starts to become unclear and it is hard to see how deliberately introducing reduced clarity can ever be desirable.

My purpose here is not oppose the idea of bank capital being a conservative measure (and I know that there are reasons deeply embedded in the IRB model’s history for why we use a downturn measure of LGD). My point is simply that the way that you pursue that conservatism has consequences and I have used Regulatory Expected Loss as an example. If the aim is simply to require a bank to hold more capital then there are alternatives (increase the correlation assumptions or increase the capital buffer ratio requirements) that achieve that outcome without distorting the REL measure.

Tell me what I am missing …

Tony