JP Morgan, other banks gaming risk models renders bank capital meaningless

As reported by Fox Business, JP Morgan and other banks have engaged in gaming their risk models so as to minimize their risk adjusted assets and maximize their capital ratios.

By doing so, the banks reveal the simple fact that bank capital and the ratios on which it is based are easily manipulated and, therefore, are meaningless.  A fact previously highlighted and reached by the OECD.

Regular readers know that bank capital is an accounting construct.  This bears repeating, bank book capital levels are an accounting construct and reflect accounting rules rather than reality.

Because it is an accounting construct, it is by definition easy to manipulate.  

By simply shifting a security from the trading account to the investment portfolio, the security goes from being subject to mark-to-market accounting to held at cost.  In a market where the value of the security is declining, which is the only market that the security will be moved to the investment portfolio, this overstates both assets and bank book capital.

Manipulation of bank book capital levels is not just something done by the banks.  It is done by the regulators too.

For example, regulators adopted regulatory forbearance at the beginning of the financial crisis.  This allowed and still allows banks to engage in 'extend and pretend' and turn non-performing loans into 'zombie' loans.  The result is that assets, net income and bank book capital levels are overstated.

In 2011, senior executives at JPMorgan Chase & Co told one of the bank's trading and hedging groups to scale back its riskier positions as new regulations would make these bets much more expensive to maintain. 

The group, called the Chief Investment Office (CIO), was asked to cut risk-weighted assets, a key measurement that regulators use when assessing a bank's stability and how much capital it needs to hold, according to a U.S. Senate subcommittee report on Thursday. 

In December 2011, the CIO came up with a plan to change its risk models. It estimated that by calculating risk differently, the bank could reduce its risk-weighted assets by $7 billion - more than half the targeted amount - without having to actually sell the securities....

Who would use an easily manipulated, accounting construct like bank book capital as a key measurement when assessing a bank's stability?

Only a market participant who is shortly to see the value of their exposure decline. [Banks with high capital levels have a history of being nationalized.  See Dexia.]

Investors say they fear that JPMorgan is not alone in tinkering with risk models to meet tougher capital requirements laid out in new regulations known as Basel III. 

Global banks are spending hundreds of millions of dollars to install elaborate computer models to measure risk and make sure they are adequately capitalized. 

Under Basel III, banks can shrink their risk-weighted assets - and boost profits - if they can build a model to prove the bond or loan is not so risky. 

While banks can use these models legitimately, they can also be tweaked to try to game the system, said Adam Compton, a portfolio manager at Atlanta-based hedge fund GMT Capital Corp. 

"You're naive if you don't think it ever happens," said Compton, who scrutinizes financial statements for banks.

The EU bank regulators have been talking about just how much difference exists between the banks on how they value and assign a risk-weight to the same asset.

A game that banks can only engage in because they are not required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants, including banking competitors, would be easily able to identify banks that are gaming the rules so as to maximize the capital ratios they show.

Capital is a key source of safety for the global banking system, and bad models could lead to undercapitalized banks. 

Many big banks were not holding enough capital when the financial crisis erupted in 2008, forcing some to fail or take government bailouts as they were unable to absorb losses.

There is a fallacy that bank capital is there to absorb losses.  In fairy tales like the Bankers' New Clothes it is, in reality it is not.

The US Treasury and Federal Reserve adopted the policy of financial failure containment and its corollary, the Geithner Doctrine years ago.  Under this policy, bank capital levels are protected at all costs because of concerns about financial contagion (if one bank fails it could bring down others).

But keeping capital levels high makes banks less profitable. 

As JPMorgan's experience with the CIO shows, the line between optimizing capital and manipulating it is fine, and often hard for outsiders - including regulators - to discern, say experts in regulatory measurements of risk.....

With ultra transparency, it would be easy for outsiders, including regulators, to see which banks are optimizing capital and which are manipulating it.

Banks need to seek regulatory approval for new risk models, but regulators may not have the time or sophistication to figure out when they are being duped, according to financial risk experts.

Basel III rules run to 616 pages, compared with 347 pages for Basel II and 30 pages for the 1988 Basel I accord. 

An examiner of bank books, who is stationed inside one of the biggest U.S. banks by a regulatory body, said regulators can - and do - back-test model changes, ask for detailed information on what specifically changed, and fight the banks on changes if they are inappropriate. 

"We are going into their credit books all the time, literally pulling out securities and testing them on the models every quarter," the regulatory examiner said...

Who can do a better job of valuing a bank's risk models:  an examiner or the market with all of its experts?

With ultra transparency, the examiner gets to piggy-back on the market's expertise in analysis.

A survey by a research analyst at Barclays Capital last year found that half of investors distrust banks' risk-weighted asset figures....

On both sides of the Atlantic, 13 of the biggest financial institutions have together announced plans to reduce their risk-weighted assets by 20 percent, or $1 trillion in total, according to consulting firm McKinsey & Co.

JPMorgan, for example, wants to reduce its risk-weighted assets by $80 billion to $100 billion. Goldman Sachs Group (GS) plans to shed $28 billion worth of risk-weighted assets by the end of this year, from $728 billion as of September 30. 

Goldman is using new technology so that traders can assess risk-weightings of individual securities more quickly, Chief Executive Lloyd Blankfein said in November. The bank has said that without its modeling efforts, upcoming Basel III rules would result in 40 percent higher risk-weighted assets, compared with the prior risk-weighting regimen....

"Risk-weighted assets used to be done by some department of the bank and no one concentrated on them; they were insignificant," the European bank source said. "Now, we're all trying to optimize them."...