Banking's tired structural fix

VoxEU.org

The systemic threat originating from sovereign debt problems in the eurozone points to the need for recapitalisation of eurozone banks well in advance of the (exceptionally slow) Basel III timetable.

Eurozone authorities have recognised this and, with market pressure intense, taken some action.

Helpful and welcome as recent moves have been, a more fundamental rethink of the Basel framework for determining minimum capital requirements for banks is needed. Basel III is just a quick and dirty repair job, consisting of patches applied to fix things that went visibly wrong during the past four years. But it involves no reconsideration of the structure of a fundamentally flawed system that is opaque and far too complex. The risk weight system at the core of the approach for calculating capital charges needs to be scrapped in its entirety and a more coherent approach to exposures arising from derivatives, notionally in excess of $600 trillion at the end of 2010, must be found.

Basel's main flaws

The central problem is that banks have almost unlimited scope to arbitrage the system by reallocating portfolios away from assets with high risk weights to assets with low risk weights, not least by trading derivatives. Given their powerful incentive to save on capital costs, they use this scope abundantly. New capital charges (eg the surcharge for 'globally systemically important banks') and stricter calibration (ie higher required ratios based on ‘risk weighted assets') just encourage more of the same.

Bank responses to Basel incentives lead to three major problems:

– Capital charges are ‘portfolio invariant'. That is, while they depend on the borrower's characteristics and the economic environment they are not influenced by whatever else is in the portfolio. There is no role for diversification in determining minimum capital requirements. This contradicts everything we have ever learned about managing portfolio risk.

– Nevertheless, the risk weights, which act as a system of regulatory taxes and subsidies, create a bias against diversification by encouraging concentration in asset classes favoured by the regulatory system. Favoured classes have been residential real estate, sovereign debt, and interbank claims, ie system interconnectedness. It is not coincidental that these have been at the heart of the crises we have been living through since 2007.

– Since minimum capital requirements can be arbitraged downward with little effective limit, the system allows far too much leverage.

Basel and derivatives

The distortions caused by the system are often obscured by its complexity and opacity, especially as regards derivatives. Consider, as an example, a Basel III innovation to deal with unexpected counterparty credit risk losses on derivatives: the charge for credit valuation adjustment, ie unrealised losses marked-to-market which the Basel Committee estimates accounted for two thirds of the total during the crisis (ie double actual defaults). The base for calculating this charge allows gross derivative positions vis--vis each counterparty to be netted out, ie bilaterally, and the charge is additive across counterparties. This may be superficially reasonable but has several unhelpful consequences.

– For large universal banks, active in highly concentrated derivative markets, it seriously underestimates the underlying exposures. Bilateral netting allows the overwhelming bulk of derivative exposures, often of the order of 90 per cent or more, to be ignored for purposes of calculating the CVA charge. But many, if not most, positions may be valued very differently if the state of the world changes. Large losses last year by the MS/MUFG joint venture in Japan following an unexpected 45 basis point move in long-term interest rates there appear to be a case in point.

– Making the CVA charge additive across netted bilateral positions rewards counterparty concentration, limiting competition in derivatives trading, since concentration effectively increases the pools within which netting is permitted.

– All this operates to minimise the CVA charge.

A simple example may be helpful. Consider a bank with four derivative exposures which cancel to nothing. In the diverse counterparty case a charge would be applied to the positive position, ie net claims, on counterparty A. But in the single counterparty case there is no charge since there is no net position. Thus there is no benefit for using a diversified group of counterparties and concentration is positively rewarded with lower capital charges. None of this makes sense.

Table 1. Bank with exposures from two interest rate swaps and two CDSs

Diverse counterparties Concentration case

Counterparty A			Single counterparty
IRS 1 (up)	100		IRS 1 (up)	100
CDS 1 (down)	-90		CDS 1 (down)	-90
Net vs. A	10
Counterparty B
IRS 2 (up)	90		IRS 2 (up)	90
CDS 2 (down)	-100		CDS 2 (down)	-100
Net vs. B	-10		Net position	0

Source: OECD Secretariat

The overall result is a vast, poorly diversified, highly interconnected banking system supported by far too small a capital base. It has little resilience or capacity to cope with adjustment so local problems too easily become systemic. Collapsing subprime real estate prices in California and Florida and excessive supply of Greek government bonds may be major problems for borrowers and lenders directly affected, but neither by themselves could create a global crisis with a resilient, well-capitalised banking system.

The Basel system should clearly be replaced with one whose parameters cannot be arbitraged by portfolio reallocation and derivative activity.

Originally published on www.VoxEU.org. Reproduced with permission.