Wednesday, January 16, 2013

Counter-cyclical capital buffers highlight foolishness of relying on complex rules and regulatory oversight

In a delightfully funny Guardian column, Simon Hoggart exposes using counter-cyclical capital buffers how foolish it is to rely on the combination of complex rules and regulatory oversight to protect the stability of the financial system.

Counter-cyclical capital buffers represent the classic example of an abstraction on an abstraction on an abstraction....

Let me explain this statement starting with the notion of "capital".

As everyone knows, bank book capital is an accounting construct.  So by definition, bank book capital is an abstraction.

In theory, book capital absorbs losses on the bank's assets that arise when investments lose value or loans stop performing.

I say in theory, because if there is any lesson that has been learned since the beginning of the financial crisis, the lesson is that so long as policymakers pursue the Japanese Model for handling a bank solvency led financial crisis, then capital is never used to absorb losses.  Instead, financial regulators suspend mark-to-market accounting and engage in regulatory forbearance that allows banks to use 'extend and pretend' to turn losses into 'zombie' loans.

So now we have two abstractions:  the first abstraction is that capital is an accounting construct; and the second abstraction is that financial regulators will let banks recognize losses.

Next, let's look at the idea of "capital buffers".

The definition of a capital buffer is according to Wikipedia, banks should hold more capital during good times so they can draw down on it during periods of economic stress.  Furthermore, the existence of a capital buffer is suppose to achieve three goals:  prevent excess credit growth, promote stronger loan loss provisioning and dampen any excess cyclicality of the minimum capital ratios.

There are two takeaways here.  First, financial regulators recognize that book capital is supposed to reflect the recognition of losses so the regulators are carving out a sliver of book capital that can be used to reflect losses.

Second, financial regulators believe that bank book capital levels act to restrict credit growth.  This wasn't true under the old banking model of originate to distribute through opaque structured finance securities ranging from covered bonds to securitizations.

It most certainly won't be true under the future banking model of originate to distribute with transparency.  The limiting factor here will be investor appetite for loans.

So now we have our third and fourth abstractions:  the third abstraction is that some book capital can absorb losses, but not all book capital can; and the fourth abstraction is that bank book capital levels are somehow a limiting factor on credit growth.

Finally, we move onto the notion of "counter cyclical".  The idea here is to increase capital when times are good and to let it be used during times of stress.

The problem with this is that the second lesson we learned from this financial crisis is that banks are capable of incurring much more in losses than they have in book capital.  This lesson directly feeds back to the first lesson and explains why policymakers won't allow banks to recognize their losses.

So now we have our fifth abstraction:  the fifth abstraction is that the size of each bank's capital buffer will magically equal the losses it has managed to incur leading up to the time of stress.

'Governor, I would now like to turn to the core indicator sets on counter-cyclical buffers," said the Tory MP David Ruffley. He was one of the MPs interrogating some of Britain's financial panjandrums, including SirMervyn King, governor of the Bank of England
All of them knew exactly what he meant. To them, the term "counter-cyclical buffer" is as meaningful as "pint of bitter, please" to the rest of us. 
As for me, my head began to loll. Stay awake, I ordered myself. Be like your famous predecessor, Bernard Levin, who used to stick a ballpoint pen under his chin, nib up, so that if he did drop off the excruciating pain would wake him. 
"The significant headwinds to internal capital generation include a rise in conduct-redressed costs," declared Andrew Bailey, who works at the FSA's prudential business unit. 
Ha! I think I know what he means. The banks are having to pay so much moolah for their shady and possibly criminal activities, eg mis-selling and Libor fixing, that they can't grab enough. They are like a drunk filling his car and spilling half the petrol. 
The experts do know they have to make some of their talk comprehensible. 
John Thurso MP said governments were "always unwilling to remove the punchbowl while the party is in full swing". It was time, he thought, "to hold the banks' feet to the fire". This sounded like quite a bash. Someone said something about "deeply complex and deeply fragile models". Well, models love parties, but what with the drugs and the anorexia, they can't eat anything, or enjoy the punch. 
By now I am alert, nose quivering like a greyhound who's just sniffed the rabbit. Two MPs start to speak in English. Labour's John Mann, never knowingly under-common-manned, leapt on someone who said the Basel agreement had to satisfy "the markets, the regulators and the banks". 
But who, he demanded, was looking after the taxpayer and the unemployed? They looked as if he'd asked what it all meant for koalas. What had taxpayers and the unemployed got to do with anything?
Please note that the Basel agreement is between the regulators and the banks.  Its origin is in hiding from the markets how much risk the banks were taking.

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