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How to be better at operational risk

Credit Suisse’s operational risk bond is a beautiful piece of financial engineering — an elegant demonstration that where there’s a buyer or seller, there’s a capital markets solution to a problem. But actually, what it demonstrates is the absurdity of operational risk rules.

So Credit Suisse, as GlobalCapital reported last week, is selling an insurance-linked security to protect it against operational risk losses. Like much of the insurance-linked market (ILS, or even catastrophe bonds, for extra drama), they are a specialist financial solution to an elegant and obscure problem.

ILS investors can also bid for extreme mortality risk (they lose money if there’s a pandemic, mass terrorist event or similar), lottery bonds (the risk of unusually large lottery payouts), earthquakes, storms, or other risks.

But the Credit Suisse deal is peculiarly unequal, compared to every other ILS trade, in that Credit Suisse can directly influence how much operational risk it runs, and, particularly, how it reports any losses.

The bank has other incentives not to fumble its operations — the bond only kicks in for losses over Sfr3bn, so there’s a substantial excess, to borrow the insurance jargon, on top of a basic desire to be perceived as competent.

But should it suffer such a loss, all of the cards are in the bank’s hands, not those of investors in the bonds.

In the capital markets, though, there’s no such thing as a bad risk, just a bad price. Credit Suisse, it seems, has come up with a good price.

There are plenty of obvious reasons to distrust Credit Suisse’s own modelling of the deal, but it arrived at 13.5bp expected loss, and a coupon of 5.5% — a juicy spread given the low rates environment.

In fact, one would expect this to be particularly attractive for Credit Suisse, which presumably has to load up on negative-yielding Switzerland Confederation bonds for regulatory reasons, while keeping plenty of US Treasuries and German Bunds on hand to support its international balance sheet.

But, of course, it has non-economic reasons to sell the risk. It’s not really about getting rid of 13.5bp expected losses for a chunky coupon; it’s about cutting the regulatory capital Credit Suisse has to allocate to operational risk. If the deal doesn’t deliver regulatory benefit, it probably wouldn't get done.

Naturally, the bank is in close touch with its home regulator on this point, at least as far as GlobalCapital understands. In the twitchy post-crisis environment, it would be crazy to do otherwise. Claiming capital relief first and asking questions later is not an option.

On the face of it, it’s perfectly sensible that regulators give capital credit for hedging risks, but the fact that Credit Suisse has, apparently, been working on a hedge for operational risk for three years, having flipped from traditional reinsurance to ILS, suggesting it really wants to sell the risk.

It has Sfr66.44bn of operational risk-weighted assets (meaning Sfr7.57bn of core equity tier one at the end of 2015), so there’s plenty of relief to claim, though the backdrop of ever-increasing lawsuits and bank errors in the period suggests it should cost it more than ever to place the risk with investors.

But the eagerness of the bank should give pause for thought. It suggests, at the very least, that the bid-offer between regulatory capital and economic capital is wide indeed — that operational risk requirements, as mandated by Basel II, are well above what Credit Suisse, and indeed Credit Suisse’s regulator, which is willing to sign-off the trade, think is economically prudent.

At least under old Basel operational risk rules there is a way to cut capital requirements. Taking out an insurance policy, whether from an insurer or from the capital markets, can cut regulatory capital by up to 20%.

No recognition

In the new rules, however, there is no such recognition. Banks assess the size of their business, using a series of formulae mainly related to gross revenue, assess the size of their operational risk losses in the past 10 years and… that’s it.

The only ways to reduce operational risk charges are to A) do less banking, or B) lose less money in the past.

Credit Suisse, in its annual report, said that it had introduced “a set of business conduct behaviours that support our desired risk culture. They are designed to encourage employees to act in ways that reduce the frequency and impact of operational risk incidents, address the root causes of past operational risk incidents in the financial services sector and other relevant industries, and touch on our ability to learn from past events.”

Perhaps that’s just corporate hot air, but from a capital perspective, it doesn’t matter how serious it is — there’s no chance the bank would get credit for it.

Being forced to measure and monitor operational risk for regulatory reasons might help such a business conduct programme to work better, but even if Credit Suisse could prove every employee had become a paragon of corporate virtue, it would still have the same regulatory operational risk charge.

The Swiss regulator’s willingness to sign-off the Credit Suisse trade might point the way to a future settlement, when the latest round of consultations is finished and the revisions added.

The most crucial change would be offering banks the chance to do better, either by hedging or by improving their processes. Bank capital is an indicator, a safety net, but also a nudge, pushing banks away from behaviours which society deems imprudent. Blocking off any way for banks to get credit for being better at operational risk is a bad move.

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