Is banking too complicated? – BIS discusses simplification of Basel III regulation

Europe is currently introducing Basel III rules. I have written about this afew weeks ago. In the US, the FED has also published draft Basel III legislation, available here.

It seems, though, that we are almost done with transforming the banking landscape. This is, at least, what I thought and hoped for, until I came across a new BIS discussion paper entitled “The regulatory framework: balancing risk sensitivity, simplicity and comparability”. The paper turns to the complexity of the current regulatory framework and introduces possible remedies.

My first reaction was mixed: On the one hand, this exactly mirrors my critique about the current framework. On the other hand, it’s a bit surprising to discuss amendments to a framework which is not even in place today. Anyway, it seems that Basel III discussions will accompany us in the foreseeable future.

If a thing can’t be done light and easy, steady and certain, let it not be done at all. Sounds strange, doesn’t it? But I’ll tell you a stranger thing. The more effort you make, the less effect you produce.

(George Bernard Shaw, Cashel Byron’s Profession)

Concepts

BIS would like to strike balance between three concepts – simplicity, comparability, and risk sensitivity.

Simplicity

The capital standard itself should be expressed in clear and straightforward language and should use precise and unambiguous terminology.

As regards the capital calculation process,

• inputs must be few in number and available through banks’ normal accounting or risk management systems;
• it should not require advanced mathematical and statistical concepts.

The reasons why simplicity might be compromised are threefold:

• To be risk sensitive, capital requirements must necessarily differ among different scenarios of exposure.
• Bank-internal models evolve continuously.
• Jurisdictions provide for capital adequacy rules under different constraints, namely the stage of development of their financial system.

Comparability

BIS wants capital standards to be comparable among banks, across jurisdictions, and over time. It recognizes that complex calculations and differences of regulation and their interpretation jeopardize such comparability.

Risk sensitivity

BIS looks at risk sensitivity from two perspectives:

• Ex ante: It is necessary for capital standards to use different risk weights, mirroring the characteristics of individual exposures and transactions.
• Ex post: The regulatory framework should be capable to vary as a function of differences in risk profiles.

One comment here: I had a hard time drafting this and this is precisely because I don’t understand what BIS is talking about here.

The institution identifies three impediments to risk sensitivity, each of them more or less common sense:

• Multiple dimensions of risk. My understanding is that BIS simply wants to say: The more facets of risk there are, the more difficult it will be to model them.
• In times of big data, data collection, storage, and analysis become ever more difficult.
• Because you cannot predict the future with certainty, you cannot construct perfectly risk sensitive models.

History of BIS risk-based capital adequacy frameworks

The first Basel framework was set up in 1988. It only considered credit risk of bank assets, i.e. the risk that the bank’s counterparty would default.

Due to increased derivatives and securitization business as well as securities trading, the framework was amended in 1990: The Basel committee introduced the notion of market risk and allowed banks to adopt internal models to calculate capital requirements.

In 2004, the Basel II package established three main new suggestions:

• Banks should take risk-based capital assessments into account for internal risk management purposes.
• The committee improved the measurement of risk-weighted assets, especially regarding credit risk.
• The new rules fixed explicit capital requirements for operational risk.

In 2007/2008, the financial crisis then revealed that the overall minimum level of capital and the quality of regulatory capital were deficient. This lead, between 2011 and 2013, to further amendments of the prudential framework: Basel 2.5 and Basel III subsequently adopted the following:

• Capital requirements for specific trading and securitization related activities were increased.
• BIS strengthened overall capital requirements by raising the minimum level of capital substantially.
• The Basel committee introduced a (non-risk based) leverage ratio as well as two new liquidity standards (i.e. liquidity coverage ratio (LCR) and net stable funding ratio (NSFR)).

In summary, the evolution since 1988 moves from simplicity and low risk sensitivity towards underlying risk to complexity and high risk sensitivity towards underlying risk. BIS writes:

“The complexity of the current framework reflects the way banking has evolved during the past few decades.”

BIS – July 2013

Factors that increase complexity of capital adequacy frameworks

In my view, this part of BIS’ report is a bit repetitive. It recognizes 8 factors:

• Greater risk-sensitivity
• Continuous innovation within financial markets, namely new financial products
• Alignment of regulatory standards over multiple jurisdictions
• Complexity of banks’ business models
• Natural tendency of regulatory regimes to accumulate complexity over time
• Tendency of those who apply regulatory frameworks to seek clarity
• Greater use of advanced mathematics in risk modeling
• Concern to create a level playing field

The above factors actually increase the complexity of the capital adequacy’s denominator (i.e. risk-weighted assets). To the contrary, BIS holds that the numerator (i.e. different definitions of capital) strikes a good balance between simplicity and risk-sensitivity.

“The more complex a bank, the harder it is to resolve when it encounters financial problems and hence the greater the value of the implicit subsidy from the perception of systemic importance.”

BIS – July 2013

Potential ideas to improve simplicity and comparability

After recognizing today’s too complex calculation of risk-weighted assets, BIS conducts a brainstorming of possible remedies:

• Explicitly recognize simplicity as an additional objective. This seems obvious; it is probably a purely political statement.
• Enhance disclosure.
• Apply and disclose results of internal models on standardized hypothetical portfolios, thereby providing insights into different modeling choices of banks.
• Apply a broader set of metrics (risk-based capital ratios, risk-weighted assets calculated under a standardized approach, capital ratios based on market values of equity, leverage ratio, risk measures derived from equity volatility, revenue-based leverage ratios (capital/revenue), historical profit volatility, price-to-book ratios, asset growth, and non-performing assets/total assets). I am wondering here whether 10 simple metrics are really better than one complex metric.
• Adjust the design and calibration of the leverage ratio, especially with regards to global systemically important banks.
• Ensure common conceptual foundations and data sources for internal risk management and regulatory models.
• Limit national discretion to improve comparability of risk-weighted assets across jurisdictions.
• Consolidate applicable Basel III standards in a single, accessible, and structured set of documents.

BIS concludes its report with three rather radical ideas for capital adequacy regulation:

• Could we measure capital adequacy using a tangible leverage ratio, i.e. tangible assets / tangible equity?
• Would it be wise to abandon internal-models altogether in favor of a combination of leverage ratio and standardized risk-based approach?
• Could it be reasonable to measure and cap the multiple of capital to income volatility?

As insinuated in my introduction, I have mitigated feelings after reading the BIS discussion paper: As a paper battling for simplicity, it is indeed not as easy to read as it should be. Some ideas are interesting; others are purely political or common sense.

Let’s wait and see which results BIS’ simplification initiative will bring.

Resource:

BISDiscussion Paper „The regulatory framework: balancing risksensitivity, simplicity and comparability“ dated July 2013

The BIS Annual Report for 2012 – “Making the most of borrowed time”

The Bank for International Settlements (BIS) is an international organization that serves central banks and financial authorities. According to its mission statement, it

• promotes monetary and financial stability,
• provides a forum for discussion and cooperation, and
• acts as a bank for its members.

At first glance, one would expect the annual report of such an organization being rather dry and technical. I have read the 83^rd annual report, published on June 14, 2013, and definitely confirm that this first impression is wrong.

As a matter of fact, the report contains a good summary and outlook of the current international financial situation as well as many interesting ideas and recommendations. I was also positively surprised by the blunt language. Finally, BIS presents a good mix of numerical information and material arguments. All this makes the report interesting to read.

The paper starts off with a summary of what happened in 2012, from a macro-economic perspective. I will not expand on this here. More interesting are BIS’ recommendations for the future. They relate to four issues:

• Roadblocks to growth
• Fiscal sustainability
• Resilience of the banking and overall financial sector
• Monetary policies

Roadblocks to growth

Creative destruction

BIS holds that rigid labor and product markets hinder long-term economic health. The reason is that people cannot move across sectors if markets are not flexible.

“Rigidities in labor and product markets are among the most important obstacles standing the way of long-term economic health.”

More specifically, the service and construction sector have shrunk substantially during the financial crisis and, today, offer less opportunities for workers. As a consequence, governments should ensure that

• shrinking sectors can let people go, e.g. fire workers and
• high-productivity sectors can develop (through abolishing entry barriers) and then hire people more easily.

“Still existing misallocation of resources among sectors of the economy must be corrected.”

“High employment protection is associated with lower employment.”

This above described reallocation process is usually called “creative destruction”.

“In the longer run, growth tends to come from new goods and services as well as innovative ways of producing and delivering them.”

Political reality

If the above process of creative destruction is so obvious – why do governments not act accordingly? BIS gives two reasons:

• Reforms will hurt well-established people and businesses and confront them with higher competition. To be precise, BIS is actually more polite: “Reforms produce losers as well as winners.”
• In the short run, reforms can make things worse. Indeed, it usually takes many years for reforms to be successful.

“Rather, it seems, policymakers act only when their hand is forced.”

“Politicians hope that if they wait, incomes and profits will start to grow again, making the reform of labor and product markets less urgent. But waiting will not make things any easier, particularly as public support and patience erode.”

Fiscal sustainability

Government debt levels

BIS says that, generally speaking, public debt in member states is too high. What’s more, increasing age-related spending will further question fiscal sustainability of government debt levels.

“Six years after the onset of the global financial crisis, public debt in most advanced economies has reached levels unprecedented in peacetime. And, worryingly, it continues to rise.”

But why specifically are high government debt levels bad? According to BIS, they hinder growth because

• higher government debt means higher interest payments means higher taxes and lower productive government spending;
• higher government debt means rising sovereign risk premia;
• higher government debt means public authorities loosing flexibility to employ countercyclical policies.

Another argument is somewhat surprising: “With low levels of debt, governments will again have the capacity to respond when the next financial or economic crisis inevitably hits.” This might be right, but, to remain politically correct, isn’t the whole work of BIS about avoiding future financial crisis?

“Finding the way to medium- and long-term fiscal sustainability remains a key challenge.”

So, which government debt thresholds are suited? According to BIS, advanced economies are safe up to 60 % of GDP; emerging market economies should not go beyond 40 % of GDP.

“Structural fiscal problems have to be tackled early. Doing so means avoiding much more pain later.”

Quality of fiscal adjustment

Quality of the fiscal adjustment also matters: Pursuant to BIS, government spending cuts are more successful than tax increases. One, spending cuts have larger fiscal multipliers. Two, it is more difficult for politicians to reverse spending cuts than to overturn tax increases.

Finally, the bank insists on the urgency for carrying out reforms: Reform fatigue might lead to politicians abandoning essential reforms.

Resilience of the banking and overall financial sector

BIS touches upon all of the current hot reform topics, i.e.:

• High quality capital buffers to protect banks against losses;
• Sufficient liquidity buffers to protect banks from sudden collapses in market confidence;
• Resolution regimes to make it possible for large and complex institutions to fail in an orderly way;
• Bank structure regulation, i.e. the separation of commercial and investment banking activities.

Capital buffers and internal risk models

On the first topic, BIS discusses namely internal risk models. The bank recognizes that they can be highly variable from one bank to the next, in particular due to

• what internal risk models actually measure (Is the capacity of the borrower measured on the basis of the prevailing macroeconomic environment or the entire business cycle? Are prevailing or stressed market conditions assumed?);
• differences in the fundamental structure of the business models;
• estimation noise (Differences in data sets lead to different statistical outcomes.);
• differences in bankers’ incentives which usually favor optimistic views on risk and low regulatory capital;
• national supervisors’ scope of intervention in setting specific model attributes.

In view of these shortcomings, risk-weighted capital ratio and liquidity ratio are complementary:

“Together, they [risk-weighted capital ratio and liquidity ratio] reinforce each-other, generate more information on the riskiness of the business of the bank, and are more difficult to be manipulated.”

In the same vein, capital adequacy and leverage ratio should, in BIS’ opinion, work together.

“Harnessing the complementary strengths of the two ratios [capital adequacy and leverage] provides an effective response to the practical and theoretical shortcomings in risk measurement.”

Another way to address the above deficiencies is improving outsiders’ understanding of risk weight calculations through

• greater transparency regarding the characteristics of internal models;
• greater comparability in the disclosures that banks make about the structure and performance of their internal models;
• greater standardization of information to allow outsiders to better compare model performance.

Bank structure regulation

With regard to bank structure regulation, BIS approves the goals of risk isolation and reduction of moral hazard. However, the bank seems rather critical, pointing to the danger of unintentional shift of financial intermediation activities outside the perimeter of consolidated supervision and to unclear interaction with other regulatory reform projects.

Reform process for the financial sector

More generally speaking, BIS defends the complexity of financial reforms, saying that “details are enforceable, principles are not”. This is actually one of the few statements in the report that I don’t agree with. In my view, the opposite is true: It’s only when you get the principles right that you can enforce details. The reason is that, in real life, the details are unfortunately never the same details that you predicted beforehand.

Related to complexity is BIS’ call for a genuine increase in loss absorption capacity as opposed to mere optimization of risk-weighted assets through redesigning transactions (“window dressing” – to use the terms of BIS). I think that, de facto, both are linked: The more complex you make it the more loopholes you will create. It’s more difficult to escape from guiding principles.

“With many elements of the new standards [of reforms of the financial sector] already in place, emphasis is gradually shifting to monitoring the pace of implementation.”

Monetary policies

“Monetary policy has fallen short of original expectations.”

“The longer the current accommodative conditions persist, the bigger the exit challenges become.”

“We are past the height of the crisis, and the goal of policy today is to return to strong and sustainable growth.”

As central banks’ balance sheets have grown massively, both in absolute terms (worldwide 20 trillion USD) and in terms of percentage of GDP (worldwide 30 % of GDP), BIS focuses on how central banks should exit from accommodative monetary policies. The challenge will be to strike a balance between the risk of exiting prematurely and the risk of exiting belatedly. Beyond timing, communication will be another key aspect to make the exit as smooth as possible.

Central Banks vs. Governments

In BIS’ view, two elements characterize the relationship between central banks and governments:

First, independence of central banks is key:

“History has shown that monetary policy decisions are best when insulated from short-term political expediency considerations, hence the importance of operational autonomy.”

Second, central banks can only influence on the framework of economies; they cannot, however, change the fundamentals.

“With monetary policies remaining very accommodative globally, central banks continue to borrow time for others to act.”

“Central banks’ accommodations have borrowed time. However, central banks cannot

• repair the balance sheets of households and financial institutions;
• ensure the sustainability of fiscal finances;
• enact the structural economic and financial reforms needed to return economies to real growth paths.“

“Our message is simple: authorities need to hasten labor and product market reforms to boost productivity and unlock growth; the private sector must deleverage and the public sector needs to ensure fiscal sustainability; risks in the financial system need to be managed; and the expectation that monetary policy can solve these problems is a recipe for failure.”

Resource:

• 83rd BIS Annual Report – 14 June 2013

Cash Crunch in China! – The People's Bank of China and the SHIBOR rate

In January 2013, the SHIBOR overnight interbank rate stood at roughly 2 %. On June 20 of this year, it peaked at 13 %. This is called a cash crunch.

On June 24, the People's Bank of China said “the onus is on lenders to better manage their own balance sheet” (Financial Times June 24, 2013). “It [PBC] also said liquidity was at a “reasonable level”, an indication of its reluctance to answer banks' pleas for cash injections to alleviate the market stress.”

Just one day later, on June 25, the PBC made a u-turn, announcing to provide Chinese banks with liquidity if need be.

And, again 3 days later, PBC's governor Zhou Xiaochuan, publicly announced: “We will use all kinds of tools and methods to appropriately adjust liquidity and to maintain the overall stability of markets”

A visualization of the full data set is available here

But what exactly is SHIBOR and how does it work?

SHIBOR is the interest rate for unsecured interbank RMB lending. Its Code of Conduct regulates SHIBOR in six articles and on roughly one page. To me, this looks great – eventually a regulator who can keep things short! Others might have an opposite reaction – such a short regulation cannot be good!

Administration

SHIBOR is regulated by the People’s Bank of China (PBC). It is the National Interbank Funding Center (NIFC), a sub-institution of PBC that does the administrative work.

Calculation and publication process

Every business day, before 11:20 a.m., SHIBOR panel banks submit quotations of borrowing and lending for the following maturities:

The quotations are based on current market conditions.

Excluding the two highest and two lowest quotations, NIFC calculates the weighted averages of the price quotations. Thereafter, the averages are published on the SHIBOR website, along with each bank’s individual quotation.

SHIBOR panel

A quoting bank must be either primary dealer in the Chinese money market or market maker in China’s FX market. Naturally, a SHIBOR panel bank must be capable to price interest rates, using an internal yield curve and a transfer pricing mechanism.

On the merits the SHIBOR working group considers elements such as transaction volume, transaction continuity, price discrepancy in prior quotations, and the bank’s credit rating.

The SHIBOR working group, a PBC internal entity, constitutes the SHIBOR panel annually.

You can find some data on SHIBOR Panel Banks here

Supervision

The SHIBOR working group of the PBC ensures the supervision. This includes evaluating the responsibility of each panel bank.

Resource:

• www.shibor.org
• www.pbc.gov.cn
• PBC press release dated June 26, 2013

Cultural change in banking – How bankers become good citizens

Banking is turning upside down. New regulation, new businesses, new ways of doing business! Nothing is as it was before and, obviously, everything is changing for the better...

Let's take the example of Deutsche Bank.

In a press conference on January 31, 2013, Deutsche Bank's CEOs Jürgen Fitschen and Anshu Jain focused (admittedly, at the end of their presentation) on the cultural change at Deutsche Bank in the near, mid and long term:

• Long-term orientation and sustainability
• Client focus
• Teamwork and partnership

Additional elements, discussed in a presentation on May 23, 2013, include Deutsche Bank's remuneration policy and its “red flag monitoring system”.

This sounds good, doesn't it?

Working for corporate and investment bank, I have also made my cultural change experience this year. The change is actually imposed by the French regulator on anybody who has changed function in the finance industry since mid 2010 and has direct client contact in his new function:

On May 24, 2013, I receive a letter from a finance training and consulting firm. I am kindly asked to prepare an exam organized by the French regulator, AMF, on July 5, 2013. The consulting firm will provide e-learning tools, documentation, and multiple choice questions to train me.

I am wondering: Is that really necessary?

I spend 5 minutes checking the underlying regulation. However, as this is (once again) very complex (different categories of people subject to different kinds of exams, different institutions authorizing and then providing the contents, etc.), I close my web browser quickly and call up the consulting firm. Friendly, but tenaciously, Julie, a member of the AMF Certification Team with the consulting firm, insists on her firm’s business model: “As you have changed function recently, this is mandatory for you!”

I call a few colleagues and get confirmation: The exam has been put in place in July 2010 as a reaction to the financial crisis. It is meant to ensure that people working in the financial sector enhance their competence and work ethics.

Next, I connect to my on-line account with the training firm to see what needs to be done. The first thing I see is a 300 pages long pdf document. I begin to get angry and decide to turn my attention to my work again.

Some weeks go by and, by mid-June, I decide to take up my preparation for the exam.

I start reading the pdf document and realize that it is about everything in finance – from banking over asset and fund management to financial markets. Much of the content is regulatory, some of it also commercial. I start reading or, rather, skimming through the document and am positively surprised as it is very well done. Nevertheless, as I have already learned all this at some time, I definitely lack motivation. Is my formerly acquired knowledge still present? Will it be sufficient to pass the exam?

The e-learning tools consist actually of animated slides. They are of the type “I explain you money laundering by showing pictures of Dollar bags lying on beaches of paradisiacal islands”. It takes certainly lots of time to produce these slides. But is it really useful?

The last part of the learning material turns out being most useful (for the exam): In a student-like manner, you respond to as many multiple choice questions as possible to get a sense of how the exam actually works and to anticipate the answers to future questions.

A few days before July 5, my COO reminds me of the upcoming exam. I feel caught out and, straightaway, register for a training session the evening before the exam.

At least, this is a good occasion to see the offices of the consultant. In one of the best areas of Paris, they are quite nice and spacious. I have learned something again – I definitely didn't know that this type of training service for the finance industry pays as well as that!

The consultant has network problems and is half an hour late. Time enough to discuss a bit with my peers. Among the few people who gather, most of them has just shown up because it is mandatory.

We go through multiple choice questions with a tutor who has 25 years of experience as a French regulator. I keep thinking – “What as waste: Here you have someone who could tell you a story about what happened in the French finance industry in the last 25 years. But, instead, he leads us through multiple choice questions and, after each question, simply ticks the right box!”

The next morning is like any other morning. I get up early, prepare breakfast for the kids and bring them to school. However, instead of going to work, I will be transformed into a better front officer this morning. I answer 100 multiple choice question about the French finance industry and its regulation and am happy to see at the end, that I have passed the exam with success.

Now let's be honest: I have actually learned a few new things through this exam. But, was that really worth my time and the money of my employer?