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The issue of testing institutional equity buffers and liquidity sources resurfaces again and again throughout this review, and we use this as a common thread throughout this article. MIAC feels that a well-informed financial institution can use their Asset Liability Committee (ALCO) process and the related Asset Liability Management (ALM) tools to stay ahead of the curve on these issues. Our ALM systems and dedicated staff can assist you with superior software and independent reviews of your assets and your process.
Context
A Market Meltdown in Perspective: Before looking at the mechanics of the bank stress tests run almost a year ago known as the Supervisory Capital Assessment Program (SCAP), or at the Basel Rules (dating from the late 1980s), it makes sense to look quickly at just what went wrong in 2007 and 2008 and understand what role capital adequacy played in that situation. In a paper by Gary Gorton and Andrew Metrick, "Securitized Banking and the Run on Repo," the authors argue that what happened was like the Panic of 1907 – a classic “run” on securitization that served as the catalyst for the crisis: "The current financial crisis is a system-wide bank run. What makes this bank run special is that it did not occur in the traditional-banking system, but instead took place in the "securitized-banking" system. A traditional-banking run is driven by the withdrawal of deposits, while a securitized-banking run is driven by the withdrawal of repurchase ("repo") agreements”
In a piece from September 2009, JP Morgan Chase agrees, saying: “But the wave of selling and demands for cash and collateral that almost destroyed all of the non-bank dealers was a function of confidence, not capital. And the same wave of selling and collateral demands would have destroyed the largest commercial banks too were it not for the extraordinary actions by the Fed to essentially float the entire rancid corpus of private label securitization.”
After discussing bank Off Balance Sheet vehicles and derivatives trades that made bank leverage effectively infinite, they conclude that: “Unless and until the leaders of the G-20 industrial nations are ready to return to deterministic limits on the activities of banks, systemic risk will remain a problem no matter how much "capital" is raised.”
Determining Capital Adequacy: The function of bank stress testing is to determine bank capital adequacy – in other words, to effectively determine if a bank’s capital level can withstand the reductions (charges) that will occur in one or more adverse scenarios. The type of credits and their granularity as compared to the bank’s total capital are a significant determinant of the likely adequacy or inadequacy of bank capital. A bank with a few large credits runs a greater risk of having most or all of their capital wiped out by a single large credit event. This argues that some banks require more capital than others just on the basis of their “lumpiness”, and not based on risk of loss alone.
The ALM Process: We at MIAC believe that stress testing should be a normal part of a financial institution’s ALM process, and that a realistic assessment of any bank’s capital adequacy should ensure that adequate “buffers” (the buffers are the minimum regulatory capital requirements) should exist over at least a two-year horizon based on a stressed economic environment.
Because a perception in the market that a bank is “in trouble” will kill its chances to obtain new equity or to de-lever via par or near-par priced asset sales, MIAC feels that early warning must be taken to protect buffers.
We feel that more than capital adequacy should be addressed by the Stress Testing / ALM process. Contingency funding plans and “disaster” planning is also appropriate. MIAC also feels that the regulators will eventually reach similar conclusions after first causing banks to over-capitalize. A review of last year’s tests and what the regulators are discussing may prove illuminating.
What Are the Tests?
The Basel Accords and Basel Capital Requirements
Basel Accords: The core is the “Three Pillars” framework concept: 1) Minimum Capital Requirements (risk); Supervisory Review; and Market Discipline (expanding market disclosures). The remainder of the framework is:
>Within the first pillar there are three types of risk: 1) Credit Risk; 2) Operational Risk; and 3) Market Risk.
>The Credit Risk component can be calculated three ways: 1) Standardized Approach (where weights are supplied by type of business); 2) Foundation IRB; and Advanced IRB (where IRB refers to “Internal Ratings-Based Approach”). The level of a bank’s sophistication in the judgment of the regulatory authorities will determine which method they can use.
The core of the process involves calculation of risk-weighted assets (RWA). Required Capital is a fixed percentage of the RWA. The Capital Adequacy Ratio (“CAR”) is derived as follows:
>The F-IRB (Foundation - Internal Ratings-Based) approach allows the banks to develop their own Probability of Default (PD or POD) assumptions relating to each borrower through an internal risk ratings methodology, while the regulators supply the Loss Given Default (LGD) assumptions.
>The A-IRB (Advanced - Internal Ratings-Based) approach allows banks to develop their own PD and LGD.
Stress Tests: In February 2009, the Treasury and the Federal Reserve Board of Governors announced their intent to conduct comprehensive and simultaneous reviews of the nation’s 19 largest Bank Holding Companies (“BHCs”) – those with more than $100 billion in assets – to determine their ability to remain well capitalized if the recession led to deeper than expected losses.
>The time horizon was a look two years forward
>Usually, bank examinations are kept confidential. This effort, formally called the Supervisory Capital Assessment Program (“SCAP”), was accompanied by an unusual amount of public information disclosure in the interests of restoring public confidence in the banking system.
>The stress test is one of the two core parts of Treasury’s Capital Assistance Program (CAP). It paved the way for the second part of the CAP, the infusion of TARP funds. An earlier MIAC Perspectives article details the plethora of federal cash infusion programs to support the financial system.
How the Tests Work – Equity Buffers
The tests projected how much capital each BHC (bank holding company) would have after absorbing the estimated losses experienced from the start of 2009 through the end of 2010. This is essentially a static, not a dynamic, ALM-based analysis. It was at this point that the supervisors determined the need for a capital buffer. If the test resulted in Tier 1 capital being less than six percent of risk weighted assets, or Tier 1common capital being less than four percent for a particular institution, that institution was required to obtain additional capital by November 2009.
Economic Scenarios: The table below shows the two economic scenarios, along with International Monetary Fund (IMF) projections and mid-2009 actual data.
Indicative Loss Rates Supplied: The BHCs were instructed by the supervisors to estimate losses from failure to pay obligations through the end of 2012 for 12 separate loan categories, based on the value of the loans shown on the BHCs’ books at the end of 2008. They were given indicative loss rates, along with the economic scenarios.
The indicative loss rate ranges were derived using a variety of methods for predicting loan losses, including analysis of historical loss experience at large BHCs and quantitative models relating the performance of loans or groups of loans to macroeconomic variables.
Bank-Level Loss Rate Setting Approach: In estimating the losses, the banking supervisors took a “horizontal” approach, with specialized teams of personnel assessing losses with respect to the same asset classes across all institutions, in order to ensure that comparable assets were valued the same way (or that differences were consistently and rationally applied) for each BHC.
Supervisors viewed these indicative ranges as useful indicators of industry loss rates and in that way they can serve as a general guide, but recognized that they might not adequately capture differences across individual firms that could affect the performance and losses in significant ways. Banks could make a case that their expected losses were lower, and regulators could also press for higher losses based on available data. Loss estimates for the SCAP thus relied ultimately on firm-specific information about factors such as past performance, origination year, borrower characteristics, and geographic distribution.
Accounting Basis: Accounting and banking rules require that banks carry loans on their books at their unpaid principal amount, reduced by a percentage reflecting the credit history of the borrower and the general risk of nonpayment for loans of the particular type. The remaining principal amount, less these provisions, is the amount that a BHC shows as assets on its balance sheet.
With respect to this method of valuation of loans, see commentary in the Panel’s April Oversight Report:
Treasury has not explained its assumption that the proper values for these assets are their book values – in the case, for example, of land or whole mortgages – and more than their “mark-to-market” value in the case of ABSs (asset-backed securities), CDOs (collateralized debt obligations), and like securities; if values fall below those floors, the banks involved may be insolvent in any event. Source: Congressional Oversight Panel, April Oversight Report: Assessing Treasury’s Strategy: Six Months of TARP, at 75 (Apr. 7, 2009) (online at cop.senate.gov/reports/library/report-040709-cop.cfm).
How Equity Buffers Work in the Real World
In the fall of 2008, Oaktree Capital’s Howard Marks wrote an article describing the capital buffer in terms of a beaker which we see as containing water on the bottom and oil above it.
The beaker is always being bounced about as it is transported. When the oil is spilled off the top, the layer protecting the water is gone. Of course, earnings can replenish the oil, as can an equity infusion. So it is with equity protecting bank deposits from losses on the asset side of the balance sheet.
Volatility: The illustrations below could also say “low asset volatility”, “Medium asset volatility” and “high asset volatility”. The concept is the same. Volatility taxes assets and the equity buffer
Leverage: The exhibits above show a greater cushion of equity for the most volatile company, which is how it should be. However leverage is seductive. Risky companies also will want to increase leverage (reduce equity) as much as possible for maximum capital efficiency. To paraphrase Howard Marks:
If you have $1 million of capital and write $25 million of loans at a 1% annual net spread, you bring in $250,000 of net margin, for a 25% return on capital (before losses and expenses). But why not write $50 million of loans and bring in $500,000? The answer is that loan losses might exceed 2% of the loans made, in which case your losses would be greater than the capital you have to pay them with . . . and you might become insolvent.
The Turner Review, the Walker Report
and the Basel Committee on Banking Supervision
Each of these reports focused more on banker behavior than on absolute levels of required capital. Some opinions are expressed that required bank capital should be increased, but increasingly the commentators are concluding that except in the cases of derivatives and Off Balance Sheet (“OBS”) vehicles, the level of capital wasn’t the primary cause of the recent crisis, and that requiring too much capital could retard lending and recovery. Summaries of the Walker Report, the Turner Review and the Basel Committee are given below. Source: International Centre for Financial Regulation, July and August 2009
The Walker Report: On July 16, 2009 Sir David Walker presented his consultative review on corporate governance in UK banks and other financial institutions (the “Review”). The review was commissioned by the Prime Minister in the light of critical loss and failure across the UK banking system. At the outset Walker makes it clear that better governance is not a substitute for more effective regulation but a complement to it and that there are limits to the role governance issues can play.
“Better governance will not guarantee that there will be no repetition of the recent highly negative experience for the economy and for society as a whole but will make a rerun of these events materially less likely”.
>Walker retains the Combined Code of the Financial Reporting Council (FRC), specifically the “comply or explain” principle and that no new primary legislation is needed.
>He maintains that the chief deficiency of banks and other financial institutions (BOFI) were behavioral not organizational. Specifically we need to foster an environment in which boards get challenged.
>Non-executive directors (NEDs) should be charged to focus on risk issues separately from the executive risk committee process.
>Fund managers and other shareholders should engage more productively with their investee companies over long-term objectives.
>There should be enhanced attention to remuneration policies in respect of variable pay, disclosures and incentives.
Turner Review: Published on March 18, 2009 by the FSA, the Review sets out various recommendations regarding possible changes to banking regulation and supervisory approaches, many of which are now under discussion within international and European intergovernmental and regulatory bodies. The Review’s proposals aim to ensure that the factors which drove the current financial crisis, including amongst others excessive leverage, inadequate capital buffers, and securitized credit market complexity, shadow banks in the maturity formation process and commercial bank involvement in risky trading activities are considered when developing a new system of effective regulation. In summary, the review recommends:
>The quality and quantity of capital in the banking system must be increased.
>Capital required against trading book activities should be increased.
>Regulators should take counter-cyclical measures, requiring more capital to be kept in good times.
>Authorities should have the power to gather information from hedge funds due to the risks that they pose and to regulate them if it becomes necessary.
>There is a need for macro-prudential and sectoral analysis in order to identify macro-prudential risks. (Simply a way to evaluate the health and soundness of a financial system through looking at indicators as the system deals with changing outside circumstances – stress tests being one evaluation technique.)
>Credit rating agencies should be regulated.
>Remuneration policies must underpin and not undermine stability. This should result in compliance and risk functions having a much greater input.
>Central counterparty and clearing systems should be developed for CDS trading.
>European deposit protection rules should be reformed and deposit protection should be pre-funded.
Basel Committee on Banking Supervision: In their publication “Strengthening the resilience of the banking sector” released December 17, 2009, there are numerous recommendations. We note the following:
“42. The Basel Committee is developing concrete proposals for a regime which would adjust the capital buffer range, established through the capital conservation proposal outlined in the previous section, when there are signs that credit has grown to excessive levels. This will ensure that banks build up countercyclical capital buffers, increasing their ability to absorb losses in a downturn.
43. The proposal is currently at an earlier stage of development and further work is needed to fully specify the details of how it would operate.”
“The tendency of market participants to behave in a procyclical manner has been amplified through a variety of channels, including through accounting standards for both mark-to-market assets and held-to-maturity loans, margining practices, and through the build up and release of leverage among financial institutions, firms, and consumers.” (Pg 15).
MIAC reads this as basically a statement that Basel is still wrangling with the issue of capital adequacy. A further report is expected in April 2010. MIAC looks forward to seeing the recommendations boiled down and made more concrete in that report.
How to Survive the Crisis:
How MIAC Can Help
MIAC believes that the jury is still out on required capital levels and appropriate bank regulation. We feel that correct answers will not be had by simply specifying a higher required capital level, and that more sophisticated approaches will be required. MIAC feels that the current 8% capital standard is arbitrary, as there have been many banks which failed with capital at or above that level prior to their failure (e.g., Barings). Capital levels above or below that level may be most appropriate for individual institutions, depending upon their risk profiles. MIAC sees more appropriate solutions being reached at the level of the individual financial institution through aggressive simulation of adverse economic climates and the impacts of those scenarios on bank assets, funding sources and capital. We feel that in the future, financial institutions will be required to continually justify their capital levels and contingency funding plans to regulators regardless of their base capital ratios, and that this is most appropriate.
MIAC has significant expertise in the loan collateral behavior which drives losses and capital depletion. Our asset valuation techniques and our ALM technology can help banks simulate the impacts on equity of local economic downturns and resulting asset performance problems.
One of the major weaknesses of many ALM systems is the inability to simulate changing credit and prepayment behavior across the credit and interest rate cycles. MIAC software integrates the best prepayment and default modeling with yield curve modeling. This allows for more accurate simulation of what can go wrong, the depletion of capital, and is directly targeted to handle the type of examination done in the Federal Reserve Bank stress tests. When coupled with rigorous liquidity planning to anticipate sudden deposit runoff and an inability to roll maturing debt financing, a comprehensive solution set to simultaneous interest rate risk, market risk, liquidity and capital management issues emerges.
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