A capital model manifesto
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A capital model manifesto

Regulators bemoan the lack of comparability in capital standards — the main point of the leverage ratio, and Basel IV, is allegedly to make the capital ratios of different banks more comparable — but the easiest fix to the problem is disclosure, not output floors. Here are GlobalCapital’s suggestions:

Transparency on operational risk:

After 10 years of ever increasing bank fines and conduct litigation, operational risk is now a vast part of the capital requirement of most investment banks. But there is little or no transparency into how it is calculated. Société Générale, for example, saw a small rise in operational risk capital requirements this quarter — but by next year, the €4.9bn it lost thanks to the Jerôme Kerviel rogue trading scandal will drop out of the 10 year backward-looking database SG uses to calculate operational risk requirements. That should, all things being equal, boost the bank’s reported capital ratio, but nobody outside the bank’s treasury team can guess by how much.

The Basel Committee is preparing a new standard, giving banks less flexibility on modelling. Bank internal models, approved by regulators, will be replaced by a more mechanistic approach. But the databases and loss events which feed into the models are still opaque, and will remain so.

Transparency on regulatory requirements 1:

There’s a long and ridiculous history to Europe’s treatment of the Pillar 2 add-on capital requirements, but the salient points are these. Pillar 2 is the extra capital regulators ask individual banks to hold, above and beyond Pillar 1 capital. In early 2016, the high ratios required (and disclosed) caused a panic in the additional tier one bond market, since it was unclear whether the securities would have their coupons switched off. Pillar 2 was then split into a “Requirement” (P2R) and “Guidance” (P2G), and only the Requirement was relevant for coupons. So banks stopped disclosing guidance at all.

Now, European bank investors have a material fact — the capital levels regulators want from the banks they supervise — which they must guess.

Transparency on regulatory requirements 2:

When regulators review banks' internal models, they are a crucial check for investors. Investors must trust them to do a good job in restraining the banks, as well as trusting bank risk management to accurately model their own risks.

But the whole process is shrouded in unjustifiable secrecy. Several banks bumped capital requirements up this quarter at regulatory request, but shied away from offering specific details. This matters to investors, however.

If a bank’s models systematically underestimate loss given default in corporate credit, why wouldn’t investors in that bank want to know? Wouldn’t that be relevant to other banks supervised in the same way? If a regulator conducts a site visit, and finds that controls for recording loan information are inadequate, that, too, should be made transparent to investors.

Permanent TSB and Bank of Ireland disclosed increased mortgage capital requirements, associated with the European Central Bank’s TRIM review of models — but said nothing at all about why regulators had decided to increase requirements for these portfolios. 

There simply is not enough information to deconstruct these rationales, and anyway, why should investors be expected to do this? Perhaps transparency wouldn’t make banks or their supervisors look good, but it would improve market discipline (supposedly a whole “Pillar” of the Basel framework).

Transparency on assets: 

There are sound business reasons for banks to conceal exactly what assets they hold. If, say, Goldman’s asset finance desk has built up a big position in non-performing shipping exposures from Germany, that information could be used against it by its competitors, and it could lose money exiting the position. Even in the more prosaic retail world, information like, for example, which sorts of borrowers ING is willing to give credit cards to, could give ABN Amro a competitive edge.

But bank reporting is so, so far away from this point. Even in the most transparent jurisdictions, it is impossible for investors to answer some of the most basic questions about the assets a given institution holds. Basel’s Pillar 3 reports come once a year, for many institutions, and even then, offer very little transparency, grouping exposures by broad type or by accounting treatment, rather than any recognisable asset class.

What would be wrong with a breakdown of asset portfolios, by model, with the output risk weight of the model? 

This wouldn’t violate any business confidentiality issues, and it would allow the market to do a real job of comparing bank business models and capital intensities, rather than the ugly compromise involved in matching leverage ratios to risk-based capital.

Transparency on liquidity:

No doubt the diligent FIG DCM bankers who read GlobalCapital have an excellent overview of the liquidity conditions of their clients. But… this information is not exactly straightforward to find. 

You will look through hundreds of pages of PDF documents and dozens of different tables to find the term structure of a bank’s liabilities, let alone how internal group funding is passed around — and therefore how liquidity might be trapped in a resolution.

Even if you can compile this, using a little guesswork about average repo maturities here, some speculation about commercial paper terms there, it is still virtually impossible to figure out what liquid assets are available to cover outflows. Banks generally report a liquidity coverage ratio, which blends together many different asset types and all outflows for 30 days into a single ratio.

But a bank which held all Bunds in its liquidity portfolio should be treated very differently to a bank with only RMBS and covered bonds (despite the haircuts). Too much disclosure could, of course, violate confidentiality, but surely a balance can be struck. Even organising existing information properly would help — given that banks generally fail because of liquidity risk, why isn't page one of every bank disclosure a simple diagram of liabilities falling due?

Before regulators add another layer of capital requirements (with all the uncertainty of implementation), why not improve disclosure about what we already have, and let the market decide? 

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