18/01/2013

A vicious circle - 01 Apr 2009 - Risk print view

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A vicious circle
/risk-magazine/feature/1497036/a-vicious-circle 01 Apr 2009, Joel Clark, Risk magazine

Critics of Basel II have long argued the rules are inherently pro-cyclical. The risk-sensitive nature of the framework means capital requirements would fall in a boom, yet rise in a downturn - a feature some claimed would force banks, facing severe capital constraints, to cut back lending in any recession, further aggravating the slump. The financial crisis has meant tackling this issue has taken on a sudden urgency. In March, the Basel Committee on Banking Supervision declared it intends to strengthen the level of capital in the banking system, partly through the introduction of capital buffers that can be drawn down in periods of stress. The unanswered question is exactly how such buffers would be calculated, and how they would fit in with international financial reporting standards, which prohibit provisioning for loan losses not yet realised. Regulators have been upping their rhetoric against the pro-cyclicality of bank capital standards over the past few months. In a speech to the Council on Foreign Relations in Washington, DC on March 10, Federal Reserve chairman Ben Bernanke said: "Capital standards, accounting rules and other regulations have made the financial sector excessively pro-cyclical. We should review capital regulations to ensure they are appropriately forward-looking, and that capital is allowed to serve its intended role as a buffer." Basel II has taken the brunt of the criticism. Under Pillar I, which covers minimum capital requirements, banks have to set risk weightings according to credit quality - meaning as the creditworthiness of borrowers declines in a recession, banks would have to hold more capital. Under the standardised approach, risk weightings are based on ratings, while banks using the internal ratings-based (IRB) approach can use their own probability of default data (as well as loss given default and exposure at default for the advanced IRB approach).
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The difficulty lies in making this inherently risk-sensitive framework less susceptible to pro-cyclicality. Some propose ripping up the Accord and starting again. The Basel Committee, however, has decided to tweak aspects of it to dampen pro-cyclical effects. "There is agreement change needs to happen, but there's also a recognition we're in a difficult part of the economic cycle," says Andrew Cross, managing director of risk measurement and management at Credit Suisse in London. "The Committee's task is to work on the change and as much as possible re-establish some credibility for how banks manage capital." The Basel Committee has already made some changes to its market risk rules. The crisis highlighted that value-at-risk models did not capture many of the risks in bank trading books, which were hit by credit migrations, credit spread widening and liquidity shortages. In addition, the use of historical data within VAR models was shown to be a major weakness. Drawing on historical data from the benign period prior to 2007 meant VAR measures were misleading and unable to predict the losses that would occur in stressed market conditions in 2008. Helmut Bauer, head of regulatory affairs at Deutsche Bank in London and Paris, says: "The current VAR regime has pro-cyclical effects because it only looks at the market data of a fairly recent past. We believe VAR should be calibrated to a level commensurate with the worst loss experience of a firm over a longer time horizon." As a consequence, the committee has proposed to supplement its existing VAR framework with a new incremental risk charge, designed to measure losses due to default and migrations. On top of that, banks will need to calculate a stressed VAR measure, using historical data from a one-year period of significant loss. The Basel Committee states the 12-month period relating to losses in 2007 and 2008 would qualify as such a period of stress for most portfolios. Taken together, these changes, scheduled for implementation from December 31, 2010, should significantly increase the market risk capital charge for trading books, even in benign market conditions (Risk March 2009, pages 25-271). Meanwhile, the UK Financial Services Authority (FSA) announced on January 19 it would amend its variable scalar methodology for converting IRB models from point-in-time to through-the-cycle. In other words, it wants to ensure banks consider the risk of a borrower over the entire cycle, so the rating (and therefore capital) assigned to that borrower does not drastically change due to shifting economic conditions. The regulator noted that several banks did not develop effective through-the-cycle estimates before the launch of Basel II, either because they did not have long enough historical data series or because the point-in-time methodology was easier. The amendment to the variable scalar method should minimise the pro-cyclical impact of point-in-time models, the regulator said. "The Basel Accord encouraged banks to think about risks through-the-cycle, but some countries encouraged point-in-time modelling," says Patricia Jackson, head of the prudential advisory practice at consultancy Ernst & Young in London and a former member of the Basel Committee. "The degree of pro-cyclicality can be vast - you can have mortgage models where the capital requirements might go up five times from boom to recession. What the FSA has done with variable scalars is really important." But regulators realise adjusting VAR measures and tweaking IRB models is not enough to significantly avert pro-cyclicality. Such steps may dampen the effects, but stronger, counter-cyclical measures are needed to ensure the problem is properly tackled. On March 12, the Basel Committee announced it would introduce standards to encourage the build-up of capital buffers to act as a cushion against losses. "The level of capital in the banking system needs to be strengthened to raise its resilience to future episodes of economic and financial stress. This will be achieved by a combination of measures, such as introducing standards to promote the build-up of capital buffers that can be drawn down in periods of stress, strengthening the quality of bank capital, improving the risk coverage of the capital framework and introducing a non-risk based supplementary measure," it wrote.
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This was echoed by the FSA on March 18 in the Turner Review, a report on banking regulation in the light of the financial crisis, conducted by FSA chairman Adair Turner. The review identified hard-wired procyclicality as an inherent problem in the banking system that worsened the impact of the financial crisis. Despite the initiatives to dampen pro-cyclicality in the Basel II framework, Turner emphasised that overtly counter-cyclical measures are also needed. "We should also go further and introduce a new counter-cyclical element to the capital regime, with capital buffers built up in good times to be drawn on in economic downturns," Turner said. Turner points to the Spanish market, which introduced a dynamic provisioning regime in 2000 to build up a capital buffer for losses that have not yet been incurred. The provision is calculated based on the difference between the average losses on loans over the business cycle (using a standard or internal model) and the amount of specific provisions already deducted. If the difference is positive, it is charged into the profit and loss (P&L) account. If it is negative, it is written as income in the P&L statement and deducted from the dynamic provision fund. In other words, when the economy is booming, the requirement for provisions increases, and this can be eaten into during downturns. While the Spanish economy is in a deep recession, its banking system appears to have weathered the storm better than others - a fact some attribute to dynamic provisioning. "By using a combination of through-thecycle probability of default, downturn loss given default and dynamic provisioning, we think pro-cyclicality becomes far less damaging in the Spanish market," says Juan Carlos Garcia Cespedes, director of global risk management at Banco Bilbao Vizcaya Argentaria (BBVA) in Madrid. "It's very important because banks may have losses in their portfolios that are not recognisable at this moment, and dynamic provisioning takes that into account. We have been able to use the buffer we had built up to stabilise loan losses in the profit and loss account." BBVA reported profits of EUR5.4 billion in 2008, down from EUR6.4 billion the year before, but an improvement on many other banks elsewhere in Europe. The ability to build up buffers and then eat into the dynamic provisions during tough times has undoubtedly helped. The provisions made by BBVA were relatively high in 2006, when the economy was still buoyant: EUR561 million compared with impairments on its assets of EUR1.5 billion. As the economy worsened and impairments started to rise, the dynamic provision requirement began to drop. Impairments reached EUR1.9 billion in 2007 and EUR2.9 billion last year, with provisions reported at EUR135 million and EUR140 million, respectively. Turner suggests a similar approach be introduced elsewhere, with capital increasing in good years when loan losses are below long-run averages, creating capital buffers that could be drawn on as losses increase. He suggests two possible approaches for the calculation of the size of the buffer. In the first, the size would be determined by regulators, who would judge the appropriate level of capital using a discretionary system based on macro-economic and macro-prudential concerns. The alternative is to use a formula based on the growth of the balance sheet or estimates of average loan losses through-the-cycle. The FSA has not specified how such a formula might work, but one possible option has been proposed by Ryozo Himino, director of the banks division at the Japanese Financial Services Agency. Writing in the March 2009 issue of Risk, Himino suggests an adjustment factor to the denominator of the capital ratio, which could be determined through a stock price index. However it is calculated, the FSA has signalled its preference for a formula-based buffer, possibly combined with regulatory discretion to add additional requirements when necessary. Industry observers agree, and suggest a consistent approach would give the greatest transparency to investors and shareholders. "A formula-based approach makes it clear what everyone is doing," says Ernst & Young's Jackson. "It would presumably still depend on assessments the firm has to make about expected loss, but a formula would
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translate this into the size of reserve needed." A discretionary approach is more problematic, as it depends on sound decision-making by a large number of national regulators, and could result in domestic political pressure on supervisors to adjust capital levels. "It is very difficult to get global regulators to agree to something that is subjective and discretionary. The formuladriven approach may not necessarily be the best answer, but it would be easier to enforce and ensure consistency," says John Tattersall, partner in the financial services regulatory practice at consultancy firm PricewaterhouseCoopers (PwC) in London. The FSA says the buffer could be structured in two ways: where the capital ratio itself varies through-thecycle; or where the buffer takes the form of a reserve deducted from capital, similar to the Spanish approach. Either way, the buffer could be as much as 2-3% of risk-weighted assets during the peak of the cycle. The Basel Committee is discussing the pros and cons of these approaches, with a decision due by the end of 2009. However, one sticking point is the accounting treatment. Under International Accounting Standard (IAS) 39, assets are only deemed impaired, and so eligible for a loan loss provision, if there is "objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the asset". The accounting rules do not permit the build-up of general provisions, unless those provisions are an attempt to estimate loan losses for which a triggering event has occurred but the individual loss has yet to be identified. The reasons for this are straightforward: if management was allowed to provision in advance for future loss, the bank would have a cushion to hide the impact of subsequent losses caused by bad management decisions. Accountants argue this methodology would significantly reduce transparency: any fund or reserve may well smooth shocks caused by unexpected events, but the resulting financial statements would no longer represent the economic characteristics of the loans in the portfolio. In a report into loan loss provisioning by the International Accounting Standards Board and the Financial Accounting Standards Board in March, the standard setters noted "economic policy and financial reporting are bad companions", and "if regulators wish to have banks behave in a manner that is counter-cyclical, they should do so through restrictions on capital". Indeed, the accounting rules have caused some to question whether Spain's dynamic provisioning regime complies with IAS 39. "When there is no evidence of existing impairment but it is likely there will be some losses over the life of the loan, dynamic provisioning enables Spanish banks to provision against future losses. That doesn't comply with IAS 39," says PwC's Tattersall. Banco de Espana counters its statistical provisioning regime does not use an expected loss model, currently prohibited under international financial reporting standards. Instead, it is a backward-looking model that uses historical data to set out provisioning levels at the balance sheet date. "The key assumption is the cyclical position," the central bank writes in a paper on the regime. "We believe that, although IAS 39 does not specifically address this issue, it does not rule out this assumption." The FSA recognises these difficulties, but expresses a preference that a counter-cyclical buffer be reflected in published account figures, as well as in calculations of required or actual capital. Turner notes that under the current accounting rules, loan loss provisions will be lower in a benign economic environment, increasing the capital of the bank, which could spur more rapid growth. Additionally, high declared profits could persuade management that further growth is desirable. While the first issue could be resolved through a counter-cyclical capital regime, the second would require adjustments in published accounts. Turner suggests an approach he claims will meet the requirements of both regulators and accountants. Existing accounting rules would be used to determine P&L and balance sheet lines for trading books and banking
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books, with loan loss provisioning continuing as before, but with the addition of a new non-distributable economic cycle reserve. This might only be shown as a movement on the balance sheet, rather than on the P&L - although Turner argues the reserve should also appear somewhere on the P&L, perhaps with bottom line profit and earnings per share calculated both before and after the economic cycle reserve. "The appropriate way forward on accounting now needs careful debate between regulators and the bodies that ultimately set published account standards," writes Turner. "We believe it important that the countercyclical approach to bank capital is reflected in highly visible published account figures." Some observers suggest the framework mooted by the FSA is indicative of an inability by regulators to bring the accounting standards bodies round to their way of thinking. "The proposals are clearly drafted to be consistent with international accounting standards. They achieve the desired result to engender countercyclicality, but it is quite an ungainly way of doing it. I have a residual unease with what is being proposed," says Tattersall. Others believe the accounting bodies should reassess the loan loss accounting rules, potentially extending the regime beyond incurred loss models. "A more through-the-cycle approach to loan loss provisioning is desirable and would enhance the resilience of the financial system," says Deutsche Bank's Bauer. "We would like to see further analysis and an open debate on a reform of the current incurred loss model and accounting standards more generally." If regulators had to resort to shifting minimum capital levels, so that core tier-one capital would rise in an upturn and be permitted to run down to the minimum level during a downturn, it could create a backlash by shareholders. "Policymakers have emphasised the idea of capital buffers going up in good times, but they often don't focus on the fact they will also have to go down in difficult times," says Credit Suisse's Cross. "That will be hard for the market to accept because investors typically want to see banks holding more capital in a downturn." The proposals are being debated by the Basel Committee. It seems certain some form of capital buffer will be introduced. "We would like to see provision levels not forced up in the middle of a crisis, as is required by current accounting standards, but do more to anticipate the need for higher provisions as these loans are taken on," says a senior Basel Committee official. "Whatever we do, we have no intention of being procyclical in the near term, and in the longer run a number of measures need to be taken to strengthen capital requirements in the banking system, including the buffer." See also: Bank losses highlight flaws in FSA capital measures Challenging times for VAR A counter-cyclical Basel II Print | Close Incisive Media Investments Limited 2013, Published by Incisive Financial Publishing Limited, Haymarket House, 28-29 Haymarket, London SW1Y 4RX, are companies registered in England and Wales with company registration numbers 04252091 & 04252093

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