basel iii
TRANSCRIPT
Electronic copy available at: http://ssrn.com/abstract=1556446
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Can Basel III work? ‐ Examining the new Capital Stability Rules by the Basel Committee
– A Theoretical and Empirical Study of Capital Buffers
Peter Miu DeGroote School of Business
McMaster University
Bogie Ozdemir*
BMO Financial Group
Michael Giesinger BMO Financial Group
Feb 2010
* Correspondence should be addressed to Bogie Ozdemir, BMO Financial Group, FCP, 100 King Street West, 23rd Floor, Toronto, Ontario, M5X 1A1, Canada, Phone: 416.643.4567, email: [email protected]. Opinions expressed in this paper are those of the authors and are not necessarily endorsed by the authors’ employers.
Electronic copy available at: http://ssrn.com/abstract=1556446
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Can Basel III work? Examining the new Capital Stability Rules by the Basel Committee
– A Theoretical and Empirical Study of Capital Buffers
Abstract: In the aftermath of the financial crisis, to reinforce the stability of the financial system, policy makers and the Basel Committee have developed proposals to ensure that financial institutions maintain sufficient capital buffers. The December proposal by the Basel Committee outlines fundamental changes and is already being called “Basel III” by the practitioners. It includes a more restrictive definition of Tier 1 Capital, use of leverage ratios, restrictions on discretionary distributions of earnings, and a “bottom‐of‐the‐cycle” calibration for the Pillar I regulatory capital requirements. In this paper we study these proposals first from a theoretical standpoint and then conduct a quantitative impact study. Recent studies and observations support increasing the quality of capital. Leverage ratios appear redundant and implementation of them would further complicate the risk optimization problem faced by financial institutions (FIs). Constraining the discretionary distributions of earnings can keep agency costs under control but needs be carefully thought through to make sure that value transfer simply does not take another form and it does not overly interfere with the FI’s dividend policies. The “bottom‐of‐the‐cycle” calibration does not look defendable. Among other problems, it could adversely affect the FI’s profitability, decelerating the capital built up by reducing the income generation per unit of capital base. Addressing the capital buffer problem within the Pillar II Internal Capital Adequacy Assessment Process (ICAAP) framework supplemented by conditional and forward looking stress testing is clearly the preferred approach.
Key words: Basel II, Basel III, Pillar I, Pillar II, Capital Buffers, Internal Capital Adequacy Assessment Process (ICAAP), Capital Adequacy, Risk Appetite, Procyclicality, Risk Capital, Available Capital, Conditional and Unconditional Value‐at‐Risk (VaR), Tier 1 Capital Adequacy Ratio, Point‐in‐Time, Through‐the‐Cycle.
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Can Basel III work? Examining the new Capital Stability Rules by the Basel Committee
– A Theoretical and Empirical Study of Capital Buffers
Overview:
The recent financial crisis showed the vulnerability of the international financial system. Financial institutions, previously perceived as unshakable, failed and capital levels of those which survived were significantly depleted. International policy makers and regulators have been working on a solution to address the vulnerabilities identified. The December 2009 paper by the Basel Committee on Banking Supervision titled “Strengthening the resilience of the banking sector” (BCBS, 2009), is already being referred to as “Basel III” by the practitioners. It is an attempt to raise the capital levels in hopes of ensuring sufficient levels are maintained during downturns and stress periods. It plays all seemingly available cards to do so: the definition of Available Capital (i.e. the supply of capital) is narrowed to raise the quality of capital, the level of Risk Capital (i.e. the demand of capital) is increased via “bottom‐of‐the‐cycle” calibration, so that throughout the cycle capital demand stays at its maximum, and discretionary distributions of earnings are restricted to prevent capital reduction during stress periods. It even has an extra safely net: if all of the above risk based measures fail, the industry is instructed to rely on leverage ratios, a reliable non‐risk based measure. In this paper, we examine each of the components of the proposal both theoretically and empirically. This discussion can only be meaningfully carried out in a Pillar II framework. Therefore, in Section 1 we define Capital Adequacy in the Pillar II framework. In Section 2 we briefly describe the new requirements. Section 3 provides a theoretical examination of the new requirements. Section 4 is an Empirical Impact Study. Section 5 is the conclusions.
Section 1 – Capital Adequacy in Pillar II framework – Definition of Capital Buffers In the Pillar II framework, Financial Institutions (FIs) design an Internal Capital Adequacy Assessment Process (ICAAP) to measure, monitor and manage the Capital Buffer between their Risk Capital and Available Capital. This Capital Buffer acts like a “Shock Absorber” and it ensures that an FI remains adequately capitalized considering its business strategy and its Risk Appetite under an expected economic outlook and as well as under stress conditions. Risk Capital is measured in terms of both Regulatory Capital (RC) and Economic Capital (EC) which is an internally estimated, more advanced measure. Available Capital is most commonly measured in terms of Tier 1 equity. Available Capital can be thought of as the supply of capital where as Risk Capital is the demand for capital representing the amount of capital required from the debt‐holders’ perspective with respect to the FI’s risk taking activities.
Figure 1: The buffer between “Available Capital” (the supply) and “Risk Capital” (the demand)
It is expected that FIs maintain a positive Capital Buffer at all times (thus Available Capital is larger than the Risk Capital) although the level of the Capital Buffer may change over the business cycle – it decreases during downturns and expands during expansions. The larger the Capital Buffer, the greater the chances that it remains positive (i.e. Risk Capital does not exceed the Available Capital). On the other hand, a Capital Buffer as a safety cushion is excess (or unused) equity on which the FI’s shareholders do not receive their required return on equity (only the Risk Capital is invested in risk taking activities thus providing a return). After the financial crisis, we see strong arguments to “build up” a capital buffer during expansionary times, to ensure capital adequacy during recessions. Capital Buffer is the difference between Available Capital and Risk Capital. While the former can be “built up” (via retaining of earnings or issuing common share), the latter can be “contained” (for example by limiting term risk) during expansionary times. Therefore, building up a capital buffer means maintaining a high surplus capital (being the difference between Available Capital and Risk Capital). However, maintaining an excessive capital surplus will hurt the FIs’ risk adjusted profitability due to unutilized Risk Capital. The FI’s Risk Appetite dictates the amount of Capital Buffer that it is targeting. Because there are two measures of Risk Capital (EC and RC), there are also two measures of Capital Buffers: (1) Tier 1 Ratio representing the Tier 1 (Available) Capital to RC relationship and (2) Available
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Capital to EC ratio. FIs, in their Risk Appetite statement for ICAAP, define the minimum acceptable Tier 1 Ratio and Available Capital to EC ratio. FIs also need to ensure that their Capital Buffers can withstand stress conditions. The Capital Buffer between Available Capital (the supply) and Risk Capital (the demand) is squeezed from both sides under stress. Risk Capital increases due to higher levels of risk (such as increased probability of default and downgrade probabilities), whereas Available Capital decreases due to reduced income and increased losses (translating into reduced or negative retained earnings).
Figure 2: Capital Buffer between “Available Capital” (the supply) and “Risk Capital” (the demand) is squeezed from both sides under stress.
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In their ICAAP, FIs test their Capital Buffers under stress conditions to ensure their Capital Buffers remain positive. More specifically, in their Risk Appetite, FIs state the minimum amount of Capital Buffer allowed under stress ‐ in terms of the Minimum Tier 1 Ratio under stress and Available Capital to EC ratio under stress. In their ICAAP exercise, FIs examine a number of topical and conditional stress scenarios, and quantify the impact on Risk Capital and Available
Stress Available Capital
Current Risk Capital
AvailableCapital
Available Capital
Risk Capital
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Capital, and finally test if their Capital Buffer, that would shrink under stress, is still larger than what is allowed in satisfying their Risk Appetite under stress.
Section 2 – Description of the New Requirements 2.1 The new definition of Tier 1 The Basel II accord originally narrowly defined Tier 1 capital to include only high quality capital elements such as permanent shareholder equity and disclosed reserves. Both elements are common in all banking systems, highly visible on financial statements, and have a significant impact on an FI’s profitability. However, this proposed definition of Tier 1 capital was later broadened to include some hybrid securities. The original Basel II framework also allowed for the inclusion of other important and legitimate elements of a bank’s capital base dependent on both the discretion of the regulators and the fulfillment of certain specific requirements outlined in the document. As a result, Tier 1 could include but is not limited to:
• Common shareholders’ equity, defined as common shares, contributed surplus and retained earnings
• Qualifying non‐cumulative perpetual preferred shares • Qualifying innovative instruments • Qualifying non‐controlling interests arising on consolidation from Tier 1 capital
instruments
• Accumulated net after‐tax foreign currency translation adjustment reported in Other Comprehensive Income (OCI)
• Accumulated net after‐tax unrealized loss on available‐for‐sale (AFS) equity securities
reported in OCI A new approach has been outlined by BCBS (2009) to strengthen the definition of Tier 1 to ensure that all qualifying elements can be used to absorb losses while the FI remains a going concern without worsening an FI’s condition in a crisis. The approach specifically suggests that FIs should reduce their reliance on non‐common equity elements of capital which are considered of lesser quality. That is, the proposal requires that Tier 1 must be predominantly common shares and retained earnings adjusted to maintain consistency among different regulatory jurisdictions. For non‐common equity elements, the requirements for inclusion in Tier 1 have been strengthened to ensure a higher quality of capital sources. Specifically, they must be loss absorbing under crisis, they must be “…subordinated, have fully discretionary non‐
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cumulative dividends or coupons and have neither a maturity date nor an incentive to redeem” (see BCBS, 2009). The new definition of Tier 1 capital also seeks to entirely exclude instruments with “innovative” features which have previously been subject only to a maximum weighting restriction of total Tier 1 capital. Such elements are typically both lower cost as well as lower quality and have, as a result, eroded the quality of Tier 1 capital due to their increased use in the last decade. Specifically, securities with “innovative” features such as “step‐ups”, indirect issues, or other redeemable instruments will be excluded. Finally, the proposal seeks to increase the transparency of Tier 1 capital by requiring a full reconciliation of all capital elements back to the balance sheet in financial statements, separate disclosure of all regulatory adjustments, a description of all limits and minima, a description of the main features of capital instruments issued, and a disclosure of ratios involving components of capital with a description of how these ratios are calculated. 2.2 Discretionary distributions of earnings
A key component of the proposal in BCBS (2009) which is now gaining considerable traction among policy‐makers is a restriction on the discretionary distributions of earnings prior to, during, and shortly after a crisis. The ultimate goal of such capital conservation measures is to maintain the stability of capital levels and require that, in the event of stress, other stakeholders do not receive compensation at the expense of creditors and, more specifically, depositors and taxpayers. At a high level, discretionary earnings distributions are any payments which, in crisis, can be reduced or eliminated entirely if it is in the best interests of the FI to do so in order to ensure that it remains a going concern. Specifically, discretionary earnings distributions include, but are not limited to, dividends on both common and preferred shares, share buy‐backs, incentive or bonus compensation, payments to pension plans, or charges associated with the optional redemption of innovative securities as included in Tier 1 capital. During the financial crisis which began in late 2007, it was noted by regulators that many FIs which had depleted their capital buffers as a result of higher than expected losses did not reduce their discretionary earnings distributions, in particular dividend payments and incentive compensation payments. These actions were justified under the assumption that industry analysts would have negatively viewed any reduction in discretionary earnings distribution as a sign of weakness potentially resulting in reputational damage to the FI. In order to prevent this in the future, the Basel Committee has proposed that a buffer range should be established above the minimum capital requirements such that, if Tier 1 capital should fall into the buffer range, FIs would be constrained in the total amount of discretionary earnings distributions. As a result, any reduction in discretionary distributions could be qualified
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under the caveat that it does not demonstrate management’s opinion of future profitability but rather can be viewed positively in that it reduces the short term drain on the bank’s capital position. One of the concerns of the industry in implementing such constraints is that the restrictions should not be so severe that they cause the buffer to become the effective minimum capital requirement. On the other hand, the restrictions must be sufficiently strong to force FIs to place the rebuilding of the capital buffer as one of its highest priorities. In order to balance these two conflicting requirements, the proposal suggests that the severity of the restrictions on discretionary distributions should increase gradually as the buffer is depleted. 2.3 Leverage Ratios Prior to the crisis, many banks built up excessive on‐ and off‐balance sheet leverage in market conditions which were relatively stable. However, when the crisis occurred, these banks were forced to deleverage which exaggerated the downward pressure on asset prices, encouraging further deleveraging, thereby entering a downward spiral in asset values which increased losses and reduced capital levels. In the past, the industry has focused primarily on risk‐based capital ratios as a determination of the appropriate level of capitalization. The high levels of leverage which occurred prior to the financial crisis were not accurately accounted for in these ratios. BCBS (2009) seeks to develop a leverage ratio which would “… constrain the build‐up of leverage in the banking sector, helping avoid destabilising deleveraging processes which can damage the broader financial system and the economy”; and reinforce the risk‐based requirements with a simple, non‐risk‐based ”backstop” measure founded on gross exposure. The Basel Committee has proposed the development of the leverage ratio as a secondary measure to be used in conjunction with Basel II risk based capital ratios. The leverage ratio will be calculated as the ratio of a high quality measure of capital, specifically Tier 1 capital and the predominant form of Tier 1 capital, and on‐ and off‐balance sheet exposure including derivatives, repos, securitization, etc. with certain adjustments to ensure international consistency. For the exposure, the Basel Committee has proposed several outstanding questions that must be discussed, including but not limited to, whether or not exposure should be the gross amount or should include accounting and regulatory netting. Currently, many global FIs already include a leverage ratio as part of their quarterly financial reporting. This leverage ratio is typically calculated as total adjusted assets divided by Tier 1 capital where adjustments include the deduction of specific intangible assets to ensure comparability between Tier 1 capital and total assets.
2.4 Bottom‐of‐the‐cycle calibration:
Adjustments to Pillar I Risk Capital were first suggested to remedy the procyclicality of the capital requirement. FIs use hybrid risk rating philosophies in assigning probabilities of default (PDs) to their obligors, with varying degrees of Point‐in‐Time (PIT)‐ness. This PIT (i.e. conditional) element1 makes the PDs procyclical which in turn makes the Pillar I Risk Capital procyclical. Gordy and Howells (2006) discussed alternative approaches – either by adjusting the inputs or output – to dampen this procyclicality. After the financial crisis, the attention of the regulators turned to “building” Capital Buffers. It was argued that the FIs need to build Capital Buffers during good economic times to ensure capital adequacy during the downturns (i.e. building up Available Capital while containing Risk Capital during good economic times). This followed the suggestions for “bottom‐of‐the‐cycle” calibration for the Pillar I Risk Capital. Under this approach, the level of Risk Capital is set to its maximum over a cycle so that no matter where we are in the cycle and what the PIT (conditional) capital requirement is, a FIs’ Risk Capital stays at its maximum. This approach seems to kill two birds with one stone. Procyclicality is eliminated and a Capital Buffer is maintained for a rainy day. Figure 3: Bottom‐of‐the‐cycle calibration sets the capital to its highest level over the cycle
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Risk Capital (t)
Bottom‐of‐the‐cycle Capital
There are alternative possible approaches discussed in the Committee of European Banking Supervisors (CEBS, 2009) and in BCBS (2009). Here we will briefly examine the two commonly‐discussed ones to achieve a “bottom‐of‐the‐cycle” calibration: (1) a time‐varying confidence level (as opposed to the constant 99.9% used in Pillar I) and (2) a portfolio level scaling factor: CEBS proposes that the Confidence Level, CL(t), used in Pillar I’s risk weight function (RW) be time‐varying which is determined to fulfill: 2,3
1 See Miu & Ozdemir (2009b) for a more specific definition of PIT‐ness
2 Confidence level is currently fixed at 99.9%.
3 RW is used to determine RC for credit risk as per Pillar I.
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RW CL=99.9%(PA‐PDMax) = RW CL(t)(PA‐PDt) where PA‐PDMax is the maximum portfolio average PD over the full business cycle and PA‐PDt is the current portfolio average PD. As long as PA‐PDMax> PA‐PDt, CL(t)>99.9%. During expansionary times when PA‐PDt is low, CL(t) is increased so that RC or RW remains unchanged. Because PA‐PDMax represents the worst PDs over a cycle, RW CL=99.9%(PA‐PDMax) represents the maximum RC required over the cycle, thus the adjustment provides a bottom‐of‐the‐cycle calibration.
In CEBS’s same discussion, as well as in BCBS (2009), a portfolio level scaling factor, SFp(t), is applied as SFp(t)= PA‐PDDown‐turn /PA‐PDt. If PA‐PDDown‐turn = PA‐PDMax, we can immediately see that this is the same adjustment discussed above, only being applied to the PDs via SFp(t) rather than to the CL(t) in order to ensure that the capital level remains approximately at the level required at the bottom‐of‐the‐cycle (or least at a downturn). More formally, the purpose is to make sure that: RW CL=99.9%(PA‐PDMax)≈ RW CL=99.9%( SF
p(t) x PA‐PDt).
Section 3 – Theoretical Examination of the New Requirements
Below we discuss the adjustments suggested by BCBS (2009) as outlined in Section 2 from a theoretical standpoint.
3.1 Tier 1 capital definition:
As discussed in Section 2.1, the new suggested definition of Tier 1 significantly narrows the type of instruments which may be classified as Tier 1, with heavy reliance on Common Shares and Retained Earnings. The previous addition of so called “hybrid” instruments, designed to allow FIs to raise capital at a lower cost and on a tax‐effective basis, is now excluded from the definition of Tier 1. This view seems to be supported by recent studies4 which suggest that the Total Common Equity to RWA ratio is a significantly better “predictor” of distress than Tier 1 to RWA and than (Tier I + Tier II) / RWA . This finding is further consistent with the observation that some of these hybrid instruments were not able to absorb losses during the last financial crisis.
4 Buehler, Samandari, and Mazingo, 2010. One caution about the results of this study: this is not a controlled experiment.
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Hybrid instruments cover three broad groups: innovative instruments (i.e. instruments with incentives to redeem such as step‐ups); non‐innovative instruments (i.e. instruments which do not have incentives to redeem); and non‐cumulative perpetual preference shares (e.g. see CEBS, 2008). These hybrid instruments are often issued by a special purpose vehicle which is created for the primary reason of raising capital for the FI and are structured to get a favourable equity treatment from ratings agencies while allowing issuers to make tax‐deductible payments (the more debt‐like the structure, the better the tax treatment and the worse the treatment from ratings agencies and vice versa). During the financial crisis, many of these hybrid instruments were downgraded by ratings agencies and were no longer able to absorb losses on a going concern basis.
The limits on the maximum amount of innovative instruments or other hybrid instruments as a percentage of total Tier 1 capital depend on the specific regulatory regime. The original Basel framework limited innovative hybrid instruments to 15% of Total Tier 1 capital. For hybrids excluding non‐cumulative preference shares, the limit varies considerably between countries. In Europe, the limit ranges between as little as 15% and as much as 50% of Total Tier 1 capital. On the other hand, in Canada, non‐common Tier 1 capital (preferred shares, innovative / hybrid instruments) could provide no more than 25% of Total Tier 1 capital (which was later increased to 40% to allow more flexibility in the financial crisis). By removing preferred shares and hybrids as elements of Tier 1 capital, the Basel proposal would ensure better comparability between different regulatory regimes given that all allowable elements of Tier 1 capital will be consistent under the Basel framework.
3.2 Discretionary distributions of earnings:
In the recent financial crisis, the banking system suffered a considerable reduction in common equity through losses on the asset portfolios of financial institutions. However, throughout that time, many banks have continued paying dividends, maintaining share buyback programs, and disbursing earnings in the form of incentive compensation even when it was no longer in the best interests of the organization. For those banks which continued their discretionary distributions of earnings given the anticipated losses associated with the financial crisis, it can be suggested that those distributions were paid to shareholders at the expense of both creditors and deposit holders. This is in effect a violation of the basic priority of the seniority of debt over equity. There is significant legal precedent which suggests that directors of financially distressed firms have a fiduciary duty to creditors as well as to shareholders.
Similarly, because common equity is typically made up of the safe marketable assets, particularly cash and government bond holdings, by paying out dividends in crisis, there is an increase in the risk and illiquidity of the remaining assets. “Paying out dividends in the form of
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cash leaves behind riskier assets on a thinner equity cushion, which benefits the shareholders once again, at the expense of the debt holders” (see Acharya et al., 2009). A common refrain from industry participants is that banks are incentivized to maintain discretionary distributions of earnings and not to raise fresh capital to avoid giving an adverse signal about the health of the bank (see Tucker, 2008). However, the side‐effect of this collective decision not to reduce discretionary payments was a considerable depletion in common equity of all FIs at a time when Tier 1 capital ratios were approaching regulatory minimums.
One study of ten large US financial institutions from 2000 to 2008 suggests that the annual dividends paid as a percentage of total assets are estimated to have increased from 0.26% in 2007 to 0.34% in 2008 after the first full year of the financial crisis.5 Among the ten large US FIs which were reviewed, two did not reduce their dividends during the crisis, three reduced or eliminated their dividend in 2008 and the remaining five reduced or eliminated their dividends in the first quarter of 2009. Although there was considerable evidence of instability in the financial markets at the beginning of 2008 (after the collapse of Bear Sterns), there was no reduction in dividends outside of those three institutions which had suffered crippling losses.
With respect to compensation, critics of existing compensation practices believe that senior managers within FIs are generally over‐ and inefficiently ‐ paid. “According to this theory, managers are able to extract significant rents because distant, diffuse, and disinterested shareholders are unable or unwilling to discipline managers, and because the board is captured and manipulated by the CEO” (see for example Henderson, 2007). In addition, existing compensation schemes generally are structured to reward based on short‐term returns which potentially ignore the long‐term implications and are often not risk‐adjusted.
The proposed changes by the Basel Committee outlined in BCBS (2009) do not attempt to resolve this misalignment of objectives between creditors and senior management. On the other hand, the proposal will reduce the discretion of senior managers when capital levels are depleted beyond a target level. The proposed implementation of a capital buffer to limit discretionary payments is designed to reduce the ability for FIs to maintain distributions of earnings in crisis by relying on future predictions of recovery as a justification. Likewise, the proposal is attempting to reduce the existing pressure to demonstrate strength in a crisis by presumptively distributing earnings even with a fragile balance sheet. As a result, senior
5 The ten US financial institutions are JP Morgan, Wells Fargo, Lehman Brothers, Wachovia Corp. Citigroup, Washington Mutual, Merrill Lynch, Morgan Stanley, Bank of America and Goldman Sachs.
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managers will be constrained in their decision making, with respect to distributions and not operations, to focus on rebuilding the capital position of the FI.
An interesting counterpoint to the proposed capital buffer can be seen in the impact the proposal may have on more conservative FIs. FIs which historically had consistent and high dividends will be penalized under the new proposal although they did not significantly contribute to the volatility during the crisis. For some investors, conservative FIs are seen as a source of predictable dividend payments and are particularly useful for pension savings.
In effect, because certain FIs have established a strong tradition of maintaining consistent dividend levels, those FIs will be forced to either raise the target minimum capital level significantly above the buffer in order to ensure predictable dividend payments or have investors potentially bear the risk of more volatile dividend payments. Unfortunately, both options will likely reduce the valuation of those FIs in the long term. The former option, to increase available capital levels well above the buffer to ensure predictable dividend payments, will reduce the return to investors while the latter, not holding extra buffer to avoid being constricted in terms of discretionary distributions, will discourage a core group of investors including pension funds who rely on stable and predicable bank dividends as a source of income. The side effect of both scenarios is a reduction in overall confidence in the banking system and an increase in the cost of capital for more conservative FIs.
As a result of political pressure from the US and UK governments, many large banks have already discussed reducing bonus compensation and increasing base salaries for senior executives. Moreover, as part of the stimulus package signed into law by President Obama, banks which were recipients of taxpayer capital through the Troubled Asset Relief Program have already restructured the compensation of senior executives to ensure that they meet the limits on bonus pay. The constraint applied under the Basel Committee proposal on discretionary bonuses will likely encourage this shift causing a significant increase in base salaries. It will be important to take into account changes in base salaries during a crisis and capture this increase as a discretionary distribution to ensure that FIs do not side‐step the restriction of discretionary distributions by shifting compensation from variable bonus compensation to fixed salaries which is not subject to the same constraints.
Ultimately, there is considerable evidence from the recent financial crisis to suggest that even a moderate reduction in discretionary distributions of earnings would have significantly improved the stability of the industry. A Bank of England report (see Bank of England, 2009) suggests that “if discretionary distributions had been 20% lower per year between 2000 and 2008, banks
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would have generated around £75B of additional capital – more than provided by the public sector during the crisis.”
3.3 Leverage Ratios:
After the crisis, the confidence on more recent risk and capital management tools such as Value‐at‐Risk (VaR) as a tail risk measure and Basel II as a whole has decreased. Therefore, at first glance, the use of more fundamental and easily understood leverage ratios as an additional tool appears to be a good way to hedge the reliance on complex risk‐based models to help ensure financial market stability.
The introduction of more risk sensitive measurement as part of the Basel II framework introduced new challenges associated with measurement and assessment of risk within large complex financial institutions. Specifically, by relying on more sophisticated risk models, regulators introduced new sources of model risk. The use of leverage ratios may help regulators to assess an FIs capital adequacy without relying on complex modeling assumptions and an FIs’ internal parameter calibration procedures. In that respect, leverage ratios provide a secondary backstop which can be used in conjunction with more complex risk‐based capital ratios (see Estrella et al., 2000). Leverage ratios have the significant benefit of being nearly costless to introduce due to their relative simplicity. In addition, the use of leverage ratios can prevent FIs from being able to perform regulatory arbitrage by structuring products to obtain higher credit ratings to qualify for more lenient capital requirements.
There are, however, a number of significant issues with leverage ratios that must be examined carefully before they are considered a reliable measure of distress. First of all, some recent studies showed that leverage ratios did not “predict” distress once risk based capital ratios are taken into account (see Buehler et al., 2010). This is not a surprising outcome as leverage ratios have the inherent limitation that they are not risk sensitive. If leverage ratios are viewed in isolation, they can incent excessive risk taking such that the financial institution has a relatively riskier balance sheet although they are complying with the ratio requirement. This issue may be remedied by including leverage ratios as a secondary measure to be used in conjunction with risk‐sensitive ratios such as the Tier 1 capital ratio. There are, however, issues with this approach as well. Many financial institutions already present the leverage ratio as the ratio of Tier 1 capital and adjusted assets. Differences in regulatory and accounting regimes can cause significant discrepancies between the treatments of certain assets. Specifically, the use of IFRS results in much higher total asset amounts and therefore lower leverage ratios compared to similar exposures for US GAAP. Studies performed by the Federal Reserve Bank of Atlanta (see Brewer et al., 2008) using the financial results of large global banks over the period of 1992 –
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2005, have demonstrated that the average leverage ratio can vary country to country between as little as 3.01% for Germany up to 8.40% for the United States. Similarly, over the same period, the average Tier 1 capital ratio was 6.27% for Germany and up to 10.04% for Switzerland. The lack of standardized assumptions surrounding the calculation of total assets in each regulatory and accounting regime can introduce a lack of comparability among countries. Moreover, leverage ratios are determined in such a way which is inconsistent with other industry practices. For example, within many global financial institutions, performance measurement, deal acceptance and portfolio management are all assessed on a risk‐adjusted basis. It may be challenging for FIs to create awareness of leverage ratios and ensure that new deal acceptance requirements take into account the marginal impact on the FIs overall leverage ratio.
Second order concerns include the lack of clarity for the interaction between leverage ratios and liquidity ratios and the noise introduced because of some conservative adjustments. For instance, the proposed assessment of exposure in the leverage ratio would be based on accounting treatment. As there are many potential differences between the accounting treatment of exposures in different accounting and regulatory regimes, a one size fits all approach will introduce noise into the system. In addition, it is unclear as to whether or not the proposed approach would take exposures as being the commitment amount or the drawn amount. The assumption that unused commitment will be fully drawn is not supported by empirical studies and, as this amount varies among different facility types and among different countries, this one size fits all approach will introduce noise in the system.
3.4 Bottom‐of‐the‐ cycle calibration:
Among the suggested changes in BCBS (2009), the “bottom–of‐the‐cycle” calibration is the most problematic from a theoretical standpoint as discussed below.
3.4.1 Embedded Historical Stress:
Under the “bottom‐of‐the‐cycle” calibration, at any point in the cycle, the capital level is equal to the most recent bottom‐of‐the cycle capital level with a buffer equal to the difference between the bottom‐of‐the‐cycle capital and current capital. We can interpret this Capital Buffer during the benign parts of the cycle as being a “historical stress” buffer.
Figure 4: Under Bottom‐of‐the‐cycle calibration, Capital Buffer incorporates Historical Stress
Risk Capital (t)
Capital Buffer
Bottom‐of‐the‐cycle Capital
However, this backward looking historical stress testing may not be relevant for both internal and external factors. The macroeconomic conditions FIs are facing may be very different from what they have faced in the past. Moreover, the portfolios currently held, and thus the risk profile, may also have changed significantly over time. In that respect, bottom‐of‐the‐cycle calibration has long memory. Consider a bank that was caught with a high risk portfolio during the last crisis but has since corrected its risk appetite, risk management practices and its management. This bank’s old mistakes will carry on in its capital buffer. The calibration also depends on how exposures changed over time. Consider two otherwise identical banks. Exposure size for Bank A changes over time based on EA(t) and for Bank B, EB(t). Assume EA(t) = EB(t+Δ), where t is time and Δ is some fixed time period. When t = bottom‐of‐the‐cycle, the bank with a larger exposure at the time would carry a larger capital buffer with the implementation of the new rules. We can make the argument that the bank whose exposure level was lower at the bottom‐of‐the‐cycle was able to reduce its exposure size more effectively and thus deserves a lower capital buffer. However, some drivers of exposure may be exogenous to the bank, in which case the differences in capital buffers between Bank A and Bank B become less justifiable.
In assessing adequacy of the Capital Buffer, the use of more relevant conditional stress testing, is clearly the preferred approach. As discussed in Section 1, this can be done in the ICAAP exercise by examining a number of topical and conditional stress scenarios, and quantify the impact on Risk Capital and Available Capital and by examining if an FI’s Capital Buffer, which would be depleted under stress, is still larger than what is required in their Risk Appetite.
3.4.2 Confidence Level:
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Under the “bottom‐of‐the‐cycle” calibration, the reference point is the RC calculated at 99.9% CL and adjustments are made to bring RC to the same level at different phases of the cycle. Therefore, the implicit assumption is that CL of 99.9% is accurate for the measurement of RC at the bottom‐of‐the‐cycle for all FIs. In reality, CL is driven by the target debt rating of the FIs and CL follows different cyclical patterns over the cycle for different target debt ratings.6 (see Miu and Ozdemir, 2009b).
3.4.3 Increased disconnect between Internal and External Estimates of Capital. With RC being more of a binding constraint for many FIs, RC may effectively replace more accurate EC.
Basel II brought Regulatory Capital (RC) closer to internally estimated Economic Capital (EC). For example in Pillar I, the Risk Weight Function was developed to approximate Economic Capital for credit risk under some simplifying assumptions.7 However, as a result of these simplifying assumptions, RC is not as accurate as EC and the error is particularly large for portfolios with large sectoral and geographical diversification and with exposures which are heterogeneous in size. Because RC cannot correctly capture the diversifiable risk of a new loan by the reference portfolio, it cannot correctly estimate marginal capital, therefore it is not appropriate for the pricing of new loans.8 Moreover, correctly capturing and managing concentration risk, which is particularly important in the aftermath of the financial crisis, is only possible with the utilization of multifactor EC models. These shortcomings of RC are well known. However, when total RC is larger than total EC, RC becomes the binding constraint for the FIs. These FIs, concerned about generating sufficient return on RC, feel the need to consider the return on RC as a measure for decision making at different levels, even including pricing and deal acceptance where RC is arguably most inappropriate.
This must be seen as an unintended consequence of Basel II. RC was not meant to replace the more accurate EC. This replacement would result in real economic risk, such as concentration risk, going unnoticed, not correctly priced and managed, and accumulated over time which, in return, would create significant systemic risk.
Under the “bottom‐of‐the‐cycle” calibration, RC will very likely materially exceed EC, especially during upturns, which will amplify the problem of RC being the binding constraint and even more so replacing EC, thus adversely altering the behavior of the banks.
6 The higher the target debt rating, the higher the CL.
7 Portfolios are assumed to be infinitely granular and there is a single source of systematic risk.
8 A multi‐factor EC model, on the other hand, can correctly capture diversifiable risk and thus an EC‐based pricing methodology correctly prices the new loans based on their correlations with the reference portfolio.
3.4.4 Neutrality of risk rating philosophies:
Although all FIs, arguably, use some form of hybrid risk rating philosophies in their PD rating systems, the degree of PIT‐ness varies among FIs. This makes the comparison of different RCs at different phases in the credit cycle not possible.
Figure 5: Without correcting for the different degree of PITness in the assessment of Risk Capital, Capital Buffers cannot be readily compared among FIs
Below we demonstrate (conditional) PDs at the sa
Consider a risk rating sysMerton’s model, the uncprobability of the asset repoint (DPm). That is,
Under the infinitely granuPillar I risk‐weighted assetime‐series average of “tr
Estimation
where θt is the default raR2 is the pair‐wise asset rehistorical default rates of
C
C
Available Capital
18
how two FIs with different levels of PITness would have different me point in the cycle, despite having the same unconditional PDs.
tem that consists of M different risk rating m = 1, 2, 3, …, M. Under onditional PD (or long‐run PD) of risk rating m is the unconditional turn of its obligors (pi,t) becoming lower than some constant default
Unconditional PD [ ]mti DPp <= ,Pr . (1)
lar single‐factor model of the economic model underlying the Basel II t function, it can be robustly estimated by evaluating the following ansformed” default rates (see Miu and Ozdemir, 2008a, for details).
of Unconditional PD ( )⎟⎟⎟
⎠
⎞
⎜⎜⎜
⎝
⎛⎟⎠
⎞⎜⎝
⎛Φ
−Φ= ∑
=
−T
ttT
R
1
121
θ (2)
tes observed for a particular risk rating from time t = 1 to T; whereas turn correlation. We can therefore estimate DPm by observing each risk rating.
apital Buffer for More TTC Bank
apital Buffer for More PIT Bank
Risk Capital
Let us examine the variation of RCs and capital buffers of two banks (Bank A and Bank B) over the business cycle. Suppose the two banks are, in every aspect, identical except for the fact that Bank B adopts a “perfect” PIT philosophy whereas that of Bank A is less PIT. For any risk rating, they therefore share the same unconditional PD and thus DPm. The “assessment of PD”, which dictates the amount of RC, will however be different between the two banks at any point in time. Let us illustrate this difference in the time‐series behavior of RC by considering the case of a single risk rating defined by the constant default point DPm. Suppose the obligors’ asset returns (pi,t) within this risk rating can be described by the following factor model (here we follow the specification of Miu and Ozdemir, 2009a).
( )[ ] titJtttti ReXXXfRp ,
221, 1,...,, ε×−++×= (3)
where εi,t is the idiosyncratic risk factor which is assumed to follow the standard normal distribution; whereas the systematic factor ( )[ ]tJ
ttt eXXXf +,...,, 21 is a function of J explanatory
(e.g. macroeconomic) variables, . The systematic factor Jttt XXX ,...,, 21 ( )[ ]tJ
ttt eXXXf +,...,, 21 is
made up of two components: (a) observable component ( )Jttt XXXf ,...,, 21 ; and (b)
unobservable component et. The unobservable component et is assumed to be normally distributed. Equation (3) therefore describes the credit risks of the obligors in the portfolios of both banks given that they are identical. For illustrative purposes and without loss of generality, let us consider an economy in which there is only a single explanatory variable X and f(X) = X. So, X is a pro‐business cycle variable. When X is high (low), we are in the booming (downturn) state of the economy when a low (high) default rate is expected to be realized. Let us start with Bank B. Given the fact that Bank B’s philosophy is perfectly PIT, at any time t, it will assess its PDt (in turn its RCt) based on the observed value of Xt at time t. Its PD assessment can therefore be expressed as: [ ]tmtit XDPpPD <= ,
BBank Pr
= ( )[ ]mtitt DPReXR <×−++× ,21Pr ε
=( )⎥⎥⎦
⎤
⎢⎢⎣
⎡
−+⋅
⋅−Φ
222 1 RRXRDP
e
tm
σ (4)
where is the cumulative standard normal distribution function and ( )•Φ eσ is the standard
deviation of et. As expected, from Equation (4), the PD assessment of Bank B (and thus its RC) is negatively related to the observed value of Xt. Its capital buffer is therefore positively related to Xt. That is, its capital buffer becomes larger during a booming state of the economy.
19
How will the PD assessment of Bank A different from that of Bank B illustrated above? Given the fact that Bank A is less PIT, even though it might observe Xt, it will not take into consideration the full effect of this observation in assessing its PD (and thus in RC).9 Suppose Bank A only considers part of Xt, denoted as Yt, in making its PD assessment. ttt ZYX += (5)
where Zt is the remaining part of Xt which is ignored in the PD assessment. The PD assessment of Bank A can therefore be expressed as: [ ]tmtit YDPpPD <= ,
ABank Pr
= ( )[ ]mtittt DPReZYR <×−+++× ,21Pr ε
=( ) ( )⎥⎥⎦
⎤
⎢⎢⎣
⎡
−++⋅
⋅−Φ
2222 1 RRYRDP
eZ
tm
σσ (6)
where Zσ is the standard deviation of Zt.
10 Comparing Equations (4) and (6), given that the variation of Yt only represents a portion of the variation of the business cycle variable Xt. the variability of (or thus the RC of Bank A) will be less than that of (or thus the RC
of Bank B) over a business cycle. The relative values of the RCs of the two banks at the bottom of a business cycle will be dictated by the relative values of the assessed PDs in Equations (4) and (6). There are two off‐setting effects. First, X
ABank tPD BBank
tPD
t tends to be more negative than Yt at the bottom of the business cycle, thus resulting in > . That is, RC of Bank B is larger
than that of Bank A (or, in other words, the capital buffer of Bank B is smaller than that of Bank A). On the other hand, the higher degree of uncertainty in the risk assessment conducted by Bank A under a less than perfect PIT philosophy will lead to a higher PD assessment. It is represented by the higher value of the denominator of Equation (6) in comparison with that of Equation (4). In ignoring Z
BBank stressPD ABank
stressPD
t, Bank A is essentially introducing an additional layer of uncertainty around its PD assessment based upon Yt. The fact that the denominator of Equation (6) is larger than that of Equation (4) will result in > .ABank
stressPD BBank stressPD 11 That is, the RC of Bank A is
larger than that of Bank B (or, in other words, capital buffer of Bank A is smaller than that of Bank B). The net effect of these two off‐setting factors will determine the relative values of RC (and thus the capital buffers) of the two banks during a downturn.
9 In the extreme situation of a perfect TTC philosophy, we can interpret it as if the bank will simply ignore Xt.
10 In deriving Equation (6), we assume Zt is independent of εi,t and et.
11 Note that the numerators of Equations (4) and (6) are likely to be negative during the downturn.
20
CEBS (2009)’s approach is considered neutral with respect to the risk rating philosophy. For a (more) PIT bank, during expansionary times, the portfolio average PD, PA‐PDt will be low(er), thus CL(t) will be large(r) so that RW CI(t) would be independent of the risk rating philosophy. This would only be true however if the maximum portfolio average PD over the cycle, PA‐PDMax
is also independent of the risk rating philosophy. The latter is not immediately obvious. The time varying confidence interval discussed in the CEBS paper (2009) is non‐neutral with respect to the risk rating philosophy. This neutrality can only be achieved by making the cyclical CL(t) also a function of the specific realization of the FIs risk rating philosophy. The same problem also exists for the portfolio level scaling factor discussed in CEBS’s same discussion paper (2009). This approach is also considered neutral with respect to the risk rating philosophy with the explanation that for a (more) PIT bank, during expansionary times, PA‐PDt
will be low(er), thus SFp (t) will be large(r) so that RW CL=99.9% would be independent of the risk rating philosophy. This would only be true, however, if PA‐PDMax is also independent of the risk rating philosophy, which is not immediately obvious. In conclusion, neither tool of the bottom‐of‐the‐cycle calibration, the time varying confidence interval nor the portfolio‐level scaling factor is necessarily neutral to the varying degrees of PIT‐ness of risk rating philosophies adopted by different FIs, which makes an apples‐to‐apples comparison among the FIs not possible. As a matter of fact, such neutrality can be achieved by decomposing hybrid risk rating philosophies into conditional and unconditional elements as discussed for example in Miu, Ozdemir (2009b). Figure 6: Capital adequacies of FIs adopting different risk philosophies are not directly comparable
21
Unconditional PD ‐ UCVaR
Less PIT Hybrid Philosophies More PIT Conditional PD‐CVaR
Bank A
Comparison of
Uncon
ditio
nal PD ‐ Va
R
Comparison of
Cond
ition
al PD ‐ Va
R
Direct Comparison
Not possible
Unconditional PD‐UCVaR
Conditional PD‐CVaR
Less PIT Hybrid Philosophies More PIT
Bank B
Section 4 – Empirical Impact Study
In considering the validity of the proposed capital buffer approach which incorporates the “bottom‐of‐the‐cycle” calibration and the capital conservation buffer, a couple of studies were performed in this section to examine the impact on realistic corporate and commercial portfolios. Analysis of historical portfolios demonstrated that PD and exposure size are the two most significant drivers of capital given a fixed type of portfolio (largely corporate exposures with consistent levels of industry diversification).
In order to eliminate the noise caused by changes in portfolio size as a result of expansion of an FI’s portfolio and capture the impact of changes in the business cycle, several assumptions were made in both studies:
• Controlled for all non‐relevant elements. Portfolio composition kept constant throughout time excluding PD migration. Long‐run average parameters were used for exposure, LGD, maturity, and correlation.
• PD migration through the business cycle was taken into account by shifting the PDs based on historical changes in the portfolio average PD. That is, the PA‐PDt for each year matched the historically measured portfolio average PD with the PDt of each obligor shifting based on the ratio between PA‐PDt and PA‐PDbase
⎟⎟⎠
⎞⎜⎜⎝
⎛−−
=base
tbaset PDPA
PDPAPDPD (7)
• The studies covered the period from 1995 to 2009.
• The base portfolio was taken to be the fourth quarter of 2009.
4.1 Corporate Portfolio
The first study was performed using a portfolio containing largely corporate exposures with some sovereign and bank exposures which had low PDs and high correlation. Risk Capital was estimated using the Basel II Pillar I’s Internal Rating Based (IRB) formula for calculating risk‐weighted assets of corporate, sovereign and bank exposures.
22
Figure 7: PD and Risk Capital Levels for a Sample Corporate Portfolio based on Historical Data from 1995 ‐ 2009
0%
20%
40%
60%
80%
100%
1995 1997 1999 2001 2003 2005 2007 2009
Capi
tal (
% o
f 200
9 C
apita
l)
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
1.4%
1.6%
1.8%
PDs
Risk Capital Obligor PDs
25% 48%
For the corporate, bank and sovereign portfolio, the largest difference between the highest level and the lowest level of Risk Capital was a 48% decrease in capital from the base year. The difference between the highest level of Risk Capital and the long‐run average Risk Capital level was a 25% decrease in capital from the base year.
4.2 Commercial Portfolio
The second study was performed using a portfolio which consists of commercial and small‐ and medium‐sized enterprise (SME) exposures. The Risk Capital was again estimated using the Basel II IRB formula for calculating risk‐weighted assets of corporate, sovereign and bank exposures with the firm‐size adjustment for small‐ and medium‐sized entities where relevant.
Figure 8: PD and Risk Capital Levels for a Sample Commercial and SME Portfolio based on Historical Data from 1995 ‐ 2009
23
0%
20%
40%
60%
80%
100%
120%
1995 1997 1999 2001 2003 2005 2007 2009
Capi
tal (
% o
f 200
9 Ca
pita
l)
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
PDs
Risk Capital PDs
11%
24%
For the commercial and SME portfolio, the largest difference between the highest and the lowest level of Risk Capital was a 24% decrease in capital from the base year. The difference between the highest level of Risk Capital and the long‐run average Risk Capital level was a 11% decrease in capital from the base year.
In comparing the two portfolios, we can make note of several key differences. Although the relative volatility of PDs for both portfolios was similar, the level of PDs for the corporate portfolio was less than half the level for the commercial portfolio. The second significant difference between the portfolio used in the first study and the portfolio used in the second study was that the average asset correlation (i.e. R‐squared in IRB implementation) was lower for the latter than the former due to the higher PDs and the firm‐size adjustment. As a result, it was expected that changes in the business cycle would have a less significant impact on changes in the Risk Capital level of the latter portfolio than the former. The results of the study shown in Figures 7 and 8 confirmed this result.
4.3 Combined Portfolio
If we combined the commercial and corporate portfolio, we can see that the Risk Capital volatility is slightly reduced and the largest difference between the highest and the lowest level of Risk Capital was a 36% decrease in capital from the base year. The difference between the highest level of Risk Capital and the long‐run average Risk Capital level was a 19% decrease in capital from the base year.
24
Figure 9: Risk Capital Levels for a Sample “Combined” Portfolio based on Historical Data from 1995 ‐ 2009
0%
20%
40%
60%
80%
100%
120%
1995 1997 1999 2001 2003 2005 2007 2009
Capi
tal (
% o
f 200
9 C
apita
l)
Risk Capital of Combined Portfolio
19% 36%
4.4 Combined Portfolio with Available Capital
The third element of the empirical study was to incorporate Available Capital, specifically Tier 1 capital, and examine the impact of the Capital Conservation Buffer on capital adequacy.
In this study, Tier 1 capital is estimated based on historical values for Tier 1 capital and Net Income. Dividends and other discretionary earnings distributions were allowed to fluctuate up to a target maximum level during expansions subject to the restrictions of the Capital Conservation Buffer outlined in BCBS (2009). As a result, Tier 1 capital (ACt) is calculated as the previous year’s Tier 1 capital plus the Net Income after disbursements in the form of share buyback or dividends to shareholders.
( )tttt ntsDisbursemeNIACAC −+= −1
(8)
BCBS (2009) states that banks should hold capital above the regulatory minimum set as the “bottom‐of‐the‐cycle” calibration. This buffer range called a “Capital Conservation Buffer” is established above minimum capital requirements. If a bank’s capital falls within this buffer
25
26
range, capital distribution constraints will be imposed. During times of stress, the buffer can be drawn down but should be rebuilt once the bank has the capacity to do so.
Banks should not use future predictions of recovery as justification for diverting earnings away from rebuilding capital buffers towards distributions to shareholders, other capital providers and employees.
BCBS (2009) outlines the general qualities of the Capital Conservation buffer and provides an example of a potential buffer to be used, although the Basel Committee suggests that the specific implementation of a buffer would require calibration in order to ensure that it has reasonable effectiveness and does not overly penalize financial institutions. The constraints placed on the bank in this study were based on the initial proposal by the Basel Committee and are outlined in the table below.
Table 1: Example of Individual Bank Minimum Capital Conservation Standards as defined by BCBS (2009)12
Amount by which Bank's capital exceeds the minimum requirement
in terms of percentage size of buffer range
Minimum Capital Conservation Ratio (required amount of retained earnings)
< 25% 100% 25% - 50% 80% 50% - 75% 60% 75% - 100% 40%
> 100% 0%
The difference between Tier 1 capital (i.e. Available Capital) and Risk Capital is the excess capital. Within the table, the excess capital is broken up into three sections:
• Structural excess capital which results from the use of downturn or bottom‐of‐the‐cycle calibration of Risk Capital.
• Capital Conservation Buffer which results from the implementation of the proposal by the Basel Committee to create a Capital Conservation Range. Under stress, the Capital Conservation Buffer can be drawn down upon, however banks in which Tier 1 capital is less than the Capital Conservation Range maximum are constrained in terms of decisions relating to discretionary earnings distributions. If the Capital Conservation
12 Numbers are illustrative and do not represent a proposed calibration level.
Buffer is zero (i.e. Tier 1 capital is less than bottom‐of‐the‐cycle Risk Capital), then the bank is undercapitalized.
• Usable Excess Capital which results from Tier 1 capital being above the maximum of the Capital Conservation Range. If Usable Excess Capital is greater than zero, then the bank is unconstrained with respect to discretionary earnings distributions.
The following examples demonstrate the results of implementing a Capital Conservation buffer as proposed by BCBS (2009). The first study is based on the assumption that the Capital Conservation buffer would have a range of 15% of bottom‐of‐the‐cycle Risk Capital. The second study is based on the assumption that the Capital Conservation buffer would have a range of 30% of bottom‐of‐the‐cycle Risk Capital. Note that in the results of both studies, the excess capital is listed as a percentage of bottom‐of‐the‐cycle Risk Capital.
Figure 10: Capital Levels for Wholesale Portfolio with 15% Capital Conservation Buffer (Note: AC – Available Capital; RC – Risk Capital)
40%
60%
80%
100%
120%
140%
1995 1996 1997 1998 1999 2000 2001 20022003 2004 2005 2006 2007 2008 2009
Cap
ital (
% o
f RC)
AC RC Downturn RC
27
In the case of the Capital Conservation buffer with a range of 15% of Risk Capital, the study shows that the year with the maximum excess capital was in 2005. In that year, structural excess capital was equal to 21% of Available Capital (or 28% of Risk Capital). At the same time, the capital conservation buffer was entirely maintained and was equal to 11% of Available
Bottom-of-the-cycle Risk Capital
Usable Excess Capital
Capital Conservation Buffer
Structural Excess Capital
Capital (or 15% of Risk Capital). Finally, the usable excess capital was equal to 15% of Available Capital (or 21% of Risk Capital).
Figure 11: Capital Levels for Wholesale Portfolio with 30% Capital Conservation Buffer (Note: AC – Available Capital; RC – Risk Capital)
40%
60%
80%
100%
120%
140%
160%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Cap
ital (
% o
f RC
)
AC RC Downturn RC
28
Similarly, if the Capital Conservation buffer had a range of 30% of Risk Capital, the study shows that structural excess capital was equal to 19% of Available Capital (or 28% of Risk Capital). At the same time, the Capital Conservation buffer was entirely maintained and was equal to 20% of Available Capital (or 30% of Risk Capital). Finally, the usable excess capital was equal to 14% of Available Capital (or 20% of Risk Capital).
The above experiment shows that with a 15% Capital Conservation buffer, the total capital surplus can reach up to 64% of Risk Capital with only 21% of it being usable and 43% being unusable (i.e. 28% Structural Excess Capital; 15% Capital Conservation Range). Similarly, it shows that with a 30% Capital Conservation buffer, the total capital surplus can reach up to 78% of Risk Capital with only 20% of it being usable and 58% being unusable (i.e. 28% Structural Excess Capital; 30% Capital Conservation Range). These levels of capital buffers do look excessive and as it is not income generating, it would significantly hurt the FI’s risk adjusted profitability. It can decelerate the capital built up by reducing the income generation per unit
Bottom-of-the-cycle Risk Capital
Usable Excess Capital
Capital Conservation Buffer
Structural Excess Capital
29
of capital base. Ironically, this outcome is the direct opposite of what is intended as an FI’s ability to replenish its capital levels during upturns is impaired.
There is also a concern of adverse incentivizing. During the expansionary times, banks whose Risk Capital level is calibrated to the bottom‐of‐the‐cycle (thus, they will need to hold high capital levels despite the low portfolio average PDs which will hurt their risk adjusted profitability due to the excess capital buffers) are incented to increase portfolio average PDs by shifting their portfolio composition towards riskier loans. Although this would make use of the excess capital buffer, it is not the desired behaviour from a systemic risk perspective.
Other unintended consequences can range from increased cost of capital and cost of borrowing for the banks which will translate into higher borrowing costs for end users of credit, reduction in available credit in the system, to reduced rates of return on equity for banks and, in the extreme, to a reduction in investor appetite as suppliers of that equity.
Section 5 – Conclusions
In this paper, we discussed the new Capital Stability Rules proposed by the Basel Committee in BCBS (2009), which is already referred to as “Basel III” by the practitioners due to its very significant implications. Our theoretical analysis identified significant shortcomings most notably for bottom‐of‐the‐cycle calibration. The impact analysis on a couple of stylized portfolios showed that Capital Surplus can reach up to 64% of Risk Capital with only 21% of it being usable and 43% being unusable during the top‐of‐the‐cycle if the Capital Conservation Range was establish as 15% of Total Risk Capital. These levels of capital surplus would significantly impair an FIs’ risk adjusted profitability and decelerate capital build‐up during the economic expansions. Other unintended consequences can range from an increased cost of capital and cost of borrowing for the FIs which will translate into higher borrowing costs for end users of credit, reduction in available credit in the system, to reduced rates of return on equity for banks and, at the extreme, to a reduction in investor appetite as suppliers of that equity. In terms of the other components of the proposal, recent studies and observations from the financial crisis support the case for increasing the quality of capital. Imposing leverage ratios appears redundant and disconnected with current practices, and implementation of which is very likely to further complicate the risk optimization problem faced by FIs. Constraining the discretionary distributions of earnings appears well intentioned to keep agency costs under control and to prevent value transfer from deposit holders to share holders. However, it needs to be carefully thought through to make sure that value transfer does not simply take another form. Another important drawback is the risk of interfering with an FIs’ dividend policies which
30
are formulated, in many cases, on very legitimate economic realities. The “bottom‐of‐the‐cycle” calibration however does not look defendable. Addressing the capital buffer problem within the Pillar II – an ICAAP framework supplemented by conditional and forward looking stress testing is clearly the preferred approach. We would like to conclude by reminding that no amount of capital is a substitute for (a lack of) sound risk and capital management. We need to be cautious about over relying on capital buffers for the aversion of a crisis. The emphasis should be on developing better risk and capital management processes, and maintaining higher quality capital.
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