Thursday, October 25, 2012

You know bank capital is meaningless when a Basel executive defends it citing need for regulatory complexity

The Financial Times ran an article in which Wayne Byres, the secretary-general of the Basel Committee on Bank Supervision, defended the enormous complexity of Basel III and provided a number of legitimate reasons why a simple formula favored by the Bank of England's Andrew Haldane and the FDIC's Thomas Hoenig doesn't work.

Your humble blogger is not going to get in the middle of this debate beyond reminding regular readers that bank capital is meaningless.  An opinion shared by the OECD.

Bank capital is meaningless because it is an easily manipulated accounting construct.

For example, when regulators adopt forbearance, banks can engage in 'extend and pretend' and transform their bad debt into 'zombie' loans.  By definition, this activity overstates both the value of the assets and the level of book capital (as the losses did not flow through earnings).

If bank book capital levels are overstated, they are meaningless.  If assets are overstated, they too are meaningless.  Dividing one meaningless number by another meaningless number does not create a meaningful number.

Allowing banks to 'risk' adjust their assets using internal models or external weightings from the Basel Committee does not change the simple fact that these risk adjusted asset levels are also meaningless.  Dividing meaningless book capital levels by meaningless risk adjusted asset levels does not create a meaningful number.

Dexia demonstrate that capital ratios are meaningless as it had great capital ratios shortly before being nationalized.

Regular readers know that the focus on bank capital is simply a way to divert attention from the real issue and that issue is transparency into each bank's exposure details.  It is only with access on an ongoing basis to each bank's current global asset, liability and off-balance sheet exposure details that market participants can assess the risk and solvency of each bank.

It is solvency that market participants care about as equity investors are first in line to lose money if the bank becomes insolvent.

With ultra transparency, market participants could adjust each bank's assets and book capital level to reflect the losses currently hidden on and off their balance sheets.  Then, if the market participants cared to, market participants could calculate capital ratios for themselves.

I realize that bank regulators are desperate to keep the focus on bank capital and not on the need for ultra transparency.  So long as the focus is on bank capital, the financial market is dependent on them.  If banks were required to provide ultra transparency, the market would no longer be dependent on them and the regulators would experience a substantial decline in their importance.

I would like to remind regular readers that so long as the market is dependent on regulators it is inherently unstable (see current financial crisis).  It is only when the market is not dependent on regulators that market discipline acts as a restraint on bank risk taking and the financial system is stable.
Bank safety rules cannot be reduced to a simple formula and recent calls to scrap the “Basel III” reform package because of its complexity are unrealistic, the secretary-general of the Basel Committee on Bank Supervision warned on Wednesday. 
“Being reliant on a single metric to capture all risks within something as complex as a modern bank is asking too much,” Wayne Byres told a Lisbon conference sponsored by the Bank of Portugal. 
The Basel package, which begins to take effect in January, uses complicated formulae and models to determine how risky a bank is and how much capital it must hold against unexpected losses.
Rather than use complicated formulae and models with millions of assumptions, doesn't it make sense to simply have the banks disclose their current exposures?
But a growing chorus of critics wants to scrap the hard-fought global agreement in favour of a much simpler metric, known as a leverage ratio, which simply divides the bank’s equity by its total assets.
I want to scrap both complicated and simple metrics.  I think that market participants should look at the actual bank exposures and determine for themselves how risky they think the bank is.
In a speech that compared running a global bank to flying a modern passenger aircraft, Mr Byres warned that banks would seek to game such a simple calculation by piling into risky, high-yielding activities. Instead, he said, regulators need to use several measures including both the leverage ratio and more complicated formulae that take riskiness into account. 
Citing Albert Einstein’s famous dictum that “everything should be as simple as possible, but not simpler”, Mr Byres said, that in banking regulation “a solution of either extreme complexity or absolute simplicity will almost inevitably be suboptimal – like most things in life, we need to find a balance between the two.”
The simplest is scrapping both measures and requiring the banks to disclose their current exposure details.

I also find it interesting that Mr. Byres thinks that bank regulation requires calculating a capital ratio.  It doesn't.

For example, the C in CAMEL Ratings used by bank examiners stands for capital adequacy and not capital ratio.  The issue addressed by capital adequacy is does the bank have enough capital to protect the taxpayer deposit guarantee for any losses it might incur on is current exposures.

Under the FDR Framework, which is the basis for most western countries financial systems, the role of the regulators is to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner so the market participants can independently assess this data and make a fully informed investment decision.

Nowhere in the FDR Framework does it say that the role of bank regulators is to calculate a capital ratio.

Regular readers know that capital ratios are a creation of regulators and came into being as a way to allow banks to leverage up their balance sheets in a hope that this would improve their Return on Equity and allow them to attract more capital. [I know because I was involved in Basel I].

Hence, the time has come to scrap any further discussion of bank capital.
Mr Byres’s speech marks the global regulator’s most cogent response to the criticism of Basel III launched in August by Andrew Haldane, director of financial stability at the Bank of England. 
Mr Haldane called on regulators to tear up the rulebook and restart in a much-cited speech entitled “The dog and the frisbee” that compared the scientific formulae needed to predict the flight of a frisbee to the actions of a dog, which simply watches the toy in flight and then moves to catch it....
The dog and the frisbee solution is exactly what market participants would do if they had access to each bank's exposure details.
But the Basel secretary-general countered the frisbee analogy with one of his own – the aircraft pilot. Modern aircraft, like global banks, are extremely complicated and it is all but impossible for users to tell whether they are safe....
It is impossible for market participants to tell if the banks are safe because as Mr. Haldane observed their disclosure leaves them resembling 'black boxes'.

However, if the banks were required to provide ultra transparency, then the users could independently determine if they were safe.
Rather than obsessing about finding the perfect formula for bank safety, Mr Byres said, regulators should focus on making sure that bankers’ personal incentives are aligned with those of their customers and investors. 
“Our goal is rather simple: to reduce the risk of flying in unsafe planes where the pilot is the only one with a parachute,” he concluded.
Given this goal, the only solution is to require the banks to provide ultra transparency.  It is only with this data that market participants can independently assess the risk of each bank and adjust their exposure to each bank based on what they can afford to lose given the risk of the bank.

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