The Cost & Effectiveness of Regulation

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Reforming the regulation of financial institutions and markets is critically important and should provide large benefits to society. The recent financial crisis underlined the huge economic costs produced by recessions associated with severe financial crises. However, adding safety margins and more complex financial regulations to the financial system comes at a price and can have predictable consequences.  The costs of this regulatory edifice are small if it improved regulators’ ability to avert future financial crises. Financial crises can be as costly as wars and waged with the weapons of the past.  The ideal for regulating a complex system is simplify the control framework and make sure the benefits of regulation outweigh the costs.

 

However, adding safety margins in the financial system comes at a price.  Most notably, the substantially stronger capital and liquidity requirements created under the new Basel III accord have economic costs during the good years, analogous to insurance payments.  There is serious disagreement about how much the additional safety margins will cost. The Institute of International Finance (IIF, 2011), bank lobbying group, project that the proposed reforms will reduce annual output in the advanced economies by approximately 3 percent by 2015. Official estimates, particularly those from the Bank for International Settlements (BIS), suggest a far smaller reduction.  The recent IMF recent Staff Discussion Paper, Estimating the Cost of Financial Regulation, by Andres Santos and Douglas Elliott (September, 2012) come closer to the BIS estimates.

 

The IMF study shows that financial reform will likely result in a modest increase in bank lending rates in the United States, Europe, and Japan in the long term. Higher safety margins in terms of capital and liquidity will lead to an increase in lenders’ operating costs, affecting bank customers, employees, and investors. Yet banks appear to have the ability to adapt to the regulatory changes without actions that would harm the wider economy. In response to the estimated rise in regulatory costs, average bank lending rates are likely to increase by 28 bps in the United States, 17 bps in Europe, and 8 bps in Japan in the long term. By comparison, the smallest increment by which major central banks adjust their short-term policy rates is 25 bps, which tends to have a small effect on economic growth. A simple framework is used to estimate the likely increase in lending rates. These rates reflect the cost of allocated capital, other funding costs, credit losses, administrative costs, and several other factors.

 

There are some important limitations to the analysis presented here. Transition costs are not examined, a number of regulatory reforms are not modeled, judgment has been required in making many of the estimates, the overall modeling approach is relatively simple, and regulatory implementation is assumed to be appropriate, not creating unnecessary costs.

 

Financial reform comes at a price. Higher safety margins, particularly in terms of greater capital and liquidity, do add operating costs for lenders. Those costs will be passed on, at least partially, to the wider economy. There is considerable uncertainty about the true cost levels, but the sensitivity analysis demonstrates that reasonable changes in assumptions would not dramatically alter the conclusions.

 

The relatively low levels of economic costs found here strongly suggest that the benefits in terms of less frequent and less costly financial crisis would indeed outweigh the costs of regulatory reforms in the long run, although this study does not attempt to estimate the economic benefits of the regulatory changes. Put another way, banks around the world appear to have a considerable ability to adapt to the regulatory changes without radical actions that would harm the wider economy.  The alternative outcome is a new financial crisis with severe wealth destruction, lost output and jobs.

 

For more on this, follow the link: www.imf.org/external/pubs/ft/sdn/2012/sdn1211.pdf

Risks on new Bank Capital Standards

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Bankers, policymakers and regulators continue to debate on the content of new bank capital requirements rather than setting global standards.  In the view of recent losses by JP Morgan and recent research reports calling for more bank capital, the need for global harmonization of standards takes on a new sense of urgency.

 

Nicholas Veron, in a recent VOXEU communique of May 4^th, The European Debate on Bank Capital is Not Just About Europe looks at the European experience.  European officials are deciding on the legislation to implement Basel III agreement on bank capital, leverage, liquidity and risk management. 

 

Officials, however, have severely underestimated the importance for reaching a global standard for financial regulation.  There are two unresolved issues in Europe: (1) the legislation’s departure from Basel III provisions; and (2) whether member states would be allowed to impose their own core requirements in regards to bank capital ratios. 

 

The first issue exists for both Europe and globally since it is about the definition of bank capital and how it should be applied to subsidiaries.  EU institutions regard global harmonization as overriding good, superseding misgivings about individual provisions or national authority.  Although, EU banking regulations are done at the national level and are not standardized creating a problem to see what is “liked” or “disliked”.  This makes the regulations vulnerable to special-interest groups. 

 

The crisis has changed the dynamics between the EU and global standards.  Institutions are now focused more on content than global harmonization.  This is complicated by a lack of a consistent approach by EU policymakers and the U.S. SEC’s delay in endorsing the proposed implementation schedule for global financial reform.  An American proposal that is compliant with Basel III would encourage EU and other doubters to comply. 

 

Global harmonization would help minimize competitive distortions inside the EU.  The main problem specific to the EU is that banking services remain under national authorities.  This results in a lack of a unified approach to bank supervision/resolution and pegs banks financial health to national authorities.  A more timely U.S. response combined with a unified EU approach could help reduce risk.

 

Although, Basel III requirements do not resolve all financial regulatory issues, a global harmonization of regulatory standards would be far better than our current fragmented system.  Perhaps the losses by JP Morgan Chase might force regulators to focus on implementation of a global standard.  The alternative of a fragmented regulatory environment could be costly.

 

For more on this simply follow the link: http://www.voxeu.org/index.php?q=node/7948

 

Capital Shortfall: A New Approach to Ranking and Regulating Systemic

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Viral Acharya, Robert Engle & Matthew Richardson, members of the faculty at NYU Stern School, provide an update on their work on systemic risk in a short VOXEU communique (dated 14^th March).  The authors discuss their method to estimate capital that a financial firm would need to raise if we have another financial crisis.

 

The effective regulation of banks requires identification of systemically important institutions.  The measure of capital shortfall is based on publically available information and is conceptually similar to the stress tests conducted by European and US regulators.

 

The authors note three potential approaches: (1) how much capital is required for an orderly rescue; (2) what is required for an orderly liquidation of systemically important institutions; and lastly, (3) how to regulate institutions according to their economic impact.  The authors prefer the latter where effective and efficient regulation requires the identification of systemically important financial institutions. 

 

A definition from Federal Reserve Governor Daniel Tarullo (2009): “Financial institutions are systemically important if the failure of the firm to meet its obligations to creditors and customers would have significant adverse consequences for the financial system and the broader economy.”   The definition makes two points: (1) what happens to the institution when it cannot perform its function due to a capital shortfall; and (2) systemic risk matters when there is an impact on the broader economy.  Systemic risk should not be described as a firm’s failure per se, but the firm’s contribution to system-wide failure.  The real systemic risk of the firm is a function of the social cost of a crisis per dollar of capital, the probability of a crisis, and the capital shortfall of the firm in a crisis. 

 

The authors provide a methodology to estimate the capital shortfall of a financial institution from its various business activities in the event of another financial crisis.  The expected capital shortfall captures in a single measure the important characteristics of systemic risk: size, leverage and interconnectedness.  All of these characteristics capture widespread losses in the financial sector are reflected in the capital shortfall and also provide information of the co-movement of a firm’s assets with the aggregate financial sector.

 

The information is based on public financial information and provides timely, accurate estimates compared to the time consuming methodology of the BIS-type stress tests.  The reader is referred to their VOXEU column and their NYU website.

 

A key lesson from this approach for risk management is that a simple, well thought out methodology, that is not time consuming, can provide the same answers as a more-complex approach.  However, the value of the results is limited by the quality of the input data.  The potential under-reporting of risk exposure, such as under Basel III, may not appear in the calculations.    

 

For more on this, follow the link:  www.voxeu.org/index.php?q=node/7722

  

Basel Regulation Needs to be Rethought in the Age of Derivatives, Part

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

  

Paul Atkinson and Adrian Blundell-Wignall, in a second VOXEU communique (Feb 29^th) suggest that further reforms are needed to change and simplify of Basel III capital rules. 

 

Atkinson and Blundell-Wignall note that the design in the Basel framework for regulating bank capital adequacy has resulted in a “vast, poorly diversified, highly interconnected banking system” supported by a far too-small capital base.  The system is inflexible to adjust to external shocks, so local problems can become systemic.  They suggest the system can be placed on a firmer foundation by the following changes:   (1) simplification of capital requirements; (2) realistic and less complex financial supervision; and (3) more reliance on market discipline. 

 

The authors suggest that a risk-weight system for capital charges be replaced by a leverage ratio with an upper limit.  This includes reporting of gross derivative positions, according to international accounting standards, in the asset base that require equity support without the distortions using netting permitted GAAP reporting rules for calculating capital charges (not always zero risk).  Otherwise, Basel III capital rules may produce outcomes that are less stable.  Bank activities should be separated into low-risk and high-risk activities (through separate subsidiaries – legal vehicles) to limit equity base exposure to losses from any single activity (trading).  This allows each subsidiary to have its own equity base while limiting government guarantee programs to specific activities such as retail banking—but not derivative trading.  This eliminates the cross-subsidization of other activities and makes the banking system less vulnerable to shocks.  

 

Liquidity management rules serve little purpose and should be replaced with a better capital-adequacy framework and resolution structure.  There are limits to supervisor’s abilities and resources which places limits on what they can accomplish.  This might suggest simplification of the regulatory structure and strive for accident prevention rather than micro management of large, complex financial institutions.

 

Lastly, there is a need to simplify and reduce bank interconnectedness to increase the reliance on market discipline.  This would allow large creditors that provide a much larger fraction of bank funding than shareholders, to be exposed to losses for their mistakes.  This combined with the leverage limits might reduce reliance on wholesale funding and trading activity.  The simplification of the complex bank interconnections could lower counterparty vulnerability to systemic risk.   The idea is to reduce the too-big-to-fail syndrome and the implicit guarantee that is associated with it.  Large bank creditors are exposed to more losses and may help limit government exposure to those activities that require high levels of capital support.

 

The failure to identify and mitigate the risks left by Basel III could be a costly mistake.

 

For more on this, follow the link: www.voxeu.org/index.php?q=node/7678

        

Rethinking Basel III and the Regulation of Derivatives

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The imposition of Basel III and the new capital requirements was seen as a way to reduce systemic risk in the financial system.  However, in the haste to implement the proposed regulations a number of flaws have emerged that mask potential risks associated with derivatives.  Paul Atkinson & Adrian Blundell-Wignall, in a recent communique, Basel Regulation Needs to be rethought in the Age of Derivatives (VOXEU, Feb 28^th) discuss some of weaknesses of Basel III.

 

The chaos that created the Eurozone debt crisis has pushed the debate on how to fix the banking system to the back burner.  The systemic threat originating from the sovereign debt crisis points for the need for recapitalizing Eurozone banks well before the Basel III timetable. Atkinson and Bludell-Wignall argue the proposed Basel III regulations are overly complicated and desperately out of date. The proposals serve as a short-term patch for a fundamentally flawed system that is overly complex.   

 

The Basel proposals use a risk-weighting system for calculating capital charges that do not fully incorporate over-the-counter derivative exposures that currently exceeds $600 trillion (end 2010).  Banks have unlimited scope to arbitrage the system by reallocating portfolios away from assets with high risk weights to assets with low risk weights, thus saving on capital costs.  The capital charges may actually encourage more risk taking by systematically important institutions and may actually make the financial system more unstable and accident prone. 

 

Bank responses to Basel incentives lead to three major problems: capital charges are portfolio invariant and depend on the borrower’s characteristics and economic environment and not portfolio composition, risk weights act as a system of regulatory taxes and subsidies and create a bias against diversification and encouraging concentration in such hazardous asset classes as US residential real estate, and the minimum capital requirements can be arbitraged downward and create a bias toward leverage.  The distortions caused by the system are often obscured by its complexity and opacity, especially as regards derivatives and accounting for unexpected counterparty credit risk losses.  The current problems with CDS, Greece and the ISDA rulings only make the problems more complicated.     

 

The Credit Valuation Adjustment (CVA) (marking unrealized losses to market) allows for the netting of gross exposures across counterparties, but may underestimate bank exposure and ignore positions for calculating the CVA charge due to highly concentrated derivative positions and bilateral netting.  The CVA charge is additive across netted bilateral positions rewarding counterparty concentration. The result is a vast, poorly diversified; highly interconnected banking system with a small capital base and that may under estimate potential risk exposure. 

 

Events such as the US subprime real estate crisis and European sovereign debt crisis may be major problems for borrowers and lenders directly affected, but a resilient, well-capitalized banking system would not allow the crisis to become global.  The Basel system should be replaced with one whose parameters cannot be arbitraged by portfolio reallocation and derivative activity.  Despite Basel III, the current system remains vulnerable to systemic risks created by derivative exposures.

 

For more on this, follow the link:  www.voxeu.org/index.php?q=node/7672

 

Systemic Risks in the Shadow Banking System

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

The role of alternative investments in the financial intermediation process has moved into the background as Basel III, Dodd-Frank and other proposed reforms are thought to solve all problems.  However, these reforms do not address all the issues, in particular the role of asset managers in the intermediation process and the role of derivatives.  Zoltan Pozsar & Manmohan Singh, two IMF economists, in The Nonbank-Bank Nexus and the Shadow Banking System (IMF Working Paper WP/11/289, December 2011) look at the role of asset managers.

 

The current view of financial regulation does not incorporate the rise of asset managers as a source of funding through the shadow banking system.  Asset managers are sources of demand for non-M2 types of money and serve as source collateral “mines” for the shadow banking system.  Banks receive funding through the re-use of pledged collateral “mined” from asset managers.  This has allowed asset managers to replace traditional creditors, primarily household retail deposits, as a key funding source to the banking system. 

 

In this process, asset managers, normally long-term investors, transform the maturity of the long-term assets into short-term liabilities (similar to bank retail deposits).  This follows the tendency to use these short-term liabilities to boost returns.  Asset managers receive cash collateral in return for the securities they loan.  It’s a gain for both parties since the cash they receive helps them to manage their funds liquidity needs (however they act like wholesale funds).

 

Using this methodology, the US shadow banking system reached $25 trillion in 2007 and declined to $18 trillion in 2010, higher than earlier estimates.  The authors suggest regulators incorporate the re-use of pledged collateral when defining prudent bank liquidity and leverage position ratios.

 

The lack of sufficient disclosure will become apparent during a period of a collateral crunch to the financial system (lack of acceptable collateral).  This will lead to greater funding stresses during a credit squeeze.  According to the authors, there was approximately US$ 5.8 trillion in off-balance sheet items of banks used for collateral mining and collateral re-use.  This is down from nearly US$ 10 trillion at the end of 2007.   The size of the number should be of concern, especially with events in Europe.

 

Monitoring the shadow banking system will warrant closer attention beyond current regulatory parameters.  Regulatory reform is focused on fortifying the equity base of the banking system and limit leverage through caps and capital adequacy requirements.  Pozsar and Singh note that the present framework of financial intermediation and data collection does not fully incorporate asset managers as funding sources for banks through the shadow banking system.  Non-bank sources of funding are thought to be sticky like retail deposits.  They note a number of weaknesses in current data availability: a broader definition of bank leverage, a breakdown of non-bank funding sources and a closer look at dealer’s ability to borrow and re-pledge collateral from various sources. 

 

They suggest an improvement in the current regulatory framework by increasing incentives for banks to move away from wholesale short-term funds into retail deposits and term funds.  Otherwise, the shadow banking system will fill the role, especially for riskier activities.  Other changes they suggest incorporating the unregulated shadow banking system more into Basel III and Dodd-Frank.  Lastly, making changes in the flow of funds data to incorporate derivatives, off-balance sheet transactions and breaking down short-term funding sources for better monitoring.  The use of off-balance sheet sources of funding should be included in risk management monitoring.  

     

For more on this follow the link: http://www.imf.org/external/pubs/ft/wp/2011/wp11289.pdf

Basel III – it’s the denominator stupid!

by Stephen McPhie, CA

Partner RSD Solutios Inc.

www.rsdsolutions.com

info@rsdsolutions.com

 

 

 

Basel I was a laudable start at trying to set up some sort of level international playing field for banks.  However, it was far too simplistic, had too many gaps and was way behind the sophistication of major market participants.  Basel II was a major theoretical step forward in the concept of risk weighting assets.  However, as we have seen, risk adjusted assets were totally and widely misstated with the result that many large banks did not have the capital to support the risks they were taking.  Now Basel III focuses on vastly more capital.  Perhaps the underlying thinking is that if we cannot calculate the denominator properly, and creative geniuses might continue to find ever more ingenious ways to make pebbles look like diamonds, then jacking up the numerator should make us all feel better.

 

Higher capital can mean lower Return on Equity, but will that encourage investors to come up with all that extra capital?  Otherwise, higher capital means higher margins on loans and higher fees on other bank products.  How are you planning for such an eventuality which will affect most businesses and people personally?