WORLDWORKS by Joe PimbleyEditor’s Note: This is the next in a Continuing Series of Articles by Joe, as excerpted from his Book;“Banking on Failure” co-authored by Laurel McDevitt.

Regulatory Tools

U.S. bank examiners employ a prudential supervisory methodology with the descriptive and memorable acronym CAMELS: “Capital adequacy; Asset quality; Management; Earnings; Liquidity; and Sensitivity to market risk.”[1] Less poetically, CAMELS also bears the alternative name “Uniform Financial Institutions Rating System” (UFIRS). The single most important and “supervisable” of these attributes is capital adequacy.

Chapters 2, 4, and 5 highlighted the critical significance of leverage for banks and corporate entities. The terms “leverage” and “capital adequacy” speak to the same topic. One widespread measure of leverage is bank assets divided by bank capital.[2] As leverage increases, there exists a point at which potential losses in the assets equal or exceed the capital. (Asset losses in excess of capital impose losses on the bank’s creditors.) Thus, banks have greater risk of failure as leverage climbs. An examiner considers a bank’s capital to be “adequate” when the leverage is less than the point at which risk of failure is unacceptably high to the regulator.

Banking on FailureIn lieu of making individual judgments of adequate or inadequate capital for each bank, regulators typically require specific minimum capital levels by type of bank. As we just noted, a minimum capital requirement relative to bank assets implies a maximum permitted leverage. As a good example, the stated “minimum risk-based capital ratio” for U.S. banks in 2016 is 8%.[3] Rather than being simply “ratio of capital to assets equals or exceeds 8%,” this regulatory standard requires that the assets be “risk-weighted” – which means that one multiplies the value of each asset by a regulator-prescribed “risk weight” that differs for each asset.

Beyond the statement that regulators choose the risk weights with the goal of specifying higher weights for higher-risk assets, we will not elaborate further on the determination of risk weights. Suffice it to say that it’s a complicated topic[4] with a long and controversial history.[5] Regarding history of risk weights and minimum capital, regulators coordinate banking regulation of their home countries through the Basel Committee for Banking Supervision (BCBS)[6] which itself is a subsidiary of the Bank for International Settlements (BIS).[7]

A recent addition to capital adequacy assessment is a “stress test” framework. The Fed created the Supervisory Capital Assessment Program (SCAP) in 2009[8] and the Comprehensive Capital Analysis and Review (CCAR) in 2011.[9] The Dodd-Frank Act also now requires the Fed to create models with hypothetical economic distress scenarios to test sufficiency of bank capital in the U.S.[10] Banks subject to Fed supervision must meet both the stated minimum capital adequacy (with risk weighting of assets) and yield a favorable result in stress tests.[11]

Following capital adequacy, the second most important bank attribute is liquidity. As chapter 5 stated, banks “die of heart attacks.” Regardless of root cause such as soured real estate loans or other reported asset losses, the immediate reason for a bank’s failure is either its inability to meet withdrawal demands of anxious depositors or its seizure by a regulator anticipating the failure to meet such withdrawal demands.

The most visible and effective regulatory tool to mitigate liquidity (“run-on-the-bank”) risk is the reserve requirement. Chapter 8 discussed this reserve requirement at some length as a tool of monetary policy. Recall that a bank’s reserve is, roughly speaking, the fraction of its deposit liabilities that it holds on deposit with the central bank or as cash in its vaults. In the U.S., the reserve requirement in 2016 is 10% of deposit liabilities.[12] Thus, to reduce banks’ liquidity risk, the central bank could increase the reserve requirement. Increased cash and reserves directly aid a bank’s ability to satisfy withdrawals and instill public confidence.

Unfortunately, the utility for monetary policy limits the central bank’s desire to adjust the reserve requirement for “safety and soundness” purposes. Though increasing the reserve requirement reduces banking system liquidity risk, this move also potentially reduces the money supply. Thus, the central bank finds a conflict between its roles of supervising the health of the banks and managing the money supply – at least when it chooses to stimulate the economy.

Such a conflict also exists to a lesser degree with the capital adequacy dimension of CAMELS. When a bank increases its capital, it must – all else equal – lend at higher interest rates or pay lower interest to depositors and other creditors to maintain its ROE (return on equity). Of course, in practice it is not the banks’ desired ROE alone that drives these interest rates. The market may or may not accommodate this shift. Further, additional bank equity capital reduces risk both for the creditors and the shareholders. It would be reasonable, therefore, for shareholders to accept a lower ROE.[13] But it remains arguable that elevated capital may increase rates for bank lending.

We’ve emphasized capital adequacy and liquidity. The remaining elements of bank examiner scrutiny (asset quality, management, earnings, and sensitivity to market risk) are either incorporated implicitly (asset quality), more difficult to measure (management), or more onerous to prescribe and enforce (earnings and market risk sensitivity). We’ve also omitted discussion of a recent “regulatory innovation” pertaining to liquidity (“liquidity coverage ratio” and “high-quality liquid assets”).[14]

Moral Hazard

There exist several variants of “moral hazard” in this arrangement of (i) governments supporting banks and (ii) governments regulating and supervising banks. We use the common phrase “moral hazard” to mean that one or more parties (banks, governments, regulators, creditors, central banks, et cetera) have unintended (?), accidental (?) incentives. For example, the most obvious moral hazard is that banks will operate with higher risk, with lower concern for failure, given the understanding that the government will (or may) rescue the bank if trading or lending losses emerge and will safeguard bank clients through deposit insurance.[15] A familiar allegation is that such regulator actions tend to “privatize the gains but socialize the losses.”[16]

Yet there are other notable moral hazards as well. Testifying before the U.S. Congress following the failure of his firm in 2008, Lehman’s CEO Richard Fuld stated that the SEC (Securities and Exchange Commission) and the Fed “actively conducted regular, and at times daily oversight of both our business and balance sheet” in 2008 before the bankruptcy filing.[17] Fuld also added that “[these regulators] were privy to everything as it was happening.”[18] Here, then, is a moral hazard: regulation diminishes accountability. That is, senior bank executives may use their full compliance with regulatory rules and requirements to diminish their accountability for bank failure. Although this ex post attempt to shift blame will fail, neither is the claim entirely without merit. Lehman in 2008, for example, held capital in excess of the regulators’ minimum requirement. It is not unreasonable for the Lehman CEO to highlight that fact.

Another moral hazard is the temptation for governments to enact their policy (i.e., “political”) objectives through mild or stronger coercion of the banking system. Since banks must hew to the (government) regulators, the government has the power to steer banks’ operations in a manner antithetical to “safety and soundness.” A stark example is government inducement to borrow funds from the banks at low cost. When banks buy sovereign debt, they are lending to the government. Regulators strongly encourage such purchases by giving zero risk weight to these government bonds.[19] While President of France in 2011, Nicolas Sarkozy stated explicitly that “each [distressed Eurozone government] can turn to its banks” for funding as a result of that year’s ECB LTRO program.[20]

In place of low-cost loans to the government that increase the banks’ risk through high concentration and contrived risk-weighting, the government may also “ask” the banks through regulation to lend to favored constituencies to promote government’s desired policies. Morgenson and Rosner argue that this practice is one of the leading causes of the U.S. subprime mortgage crisis that began in 2007.[21] Calomiris and Haber claim generally that such “political bargaining” is central to banking operation in both authoritarian and democratic societies.[22]

More specifically, Calomiris-Haber argues the identical thesis of Morgenson-Rosner that U.S. government policy pushed the nation’s banks to eviscerate residential mortgage loan underwriting criteria[23] as do numerous other experts.[24] The government created a commission of politicians and government officials and employees, the Financial Crisis Inquiry Commission (FCIC), to determine causes of the Credit Crisis. In its 2011 report, the majority of the FCIC rejected explanations that faulted government policy.[25]

[1] See the on-line handbook for the OCC’s bank supervision process at http://www.occ.gov/publications/publications-by-type/comptrollers-handbook/index-comptrollers-handbook.html . Also see Appendix C of E. V. Murphy, “Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy for Banking and Securities Markets,” Congressional Research Service, May 2013.

[2] The precise meaning of “capital” varies with context. Bank capital may just be the firm’s common equity. Often, though, capital has a broader definition that includes preferred stock and subordinated debt as well as common equity.

[3] See Table A-I of E. V. Murphy, “Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy for Banking and Securities Markets,” Congressional Research Service, May 2013.

[4] See, for example, “Part 2: The First Pillar – Minimum Capital Requirements,” Basel Committee of Banking Supervision.

[5] The Basel Committee on Banking Supervision (BCBS) created the Basel Capital Accord in 1988 with “risk weight formulas” for bank capital adequacy. See http://www.bis.org/bcbs/history.htm . See also J. M. Pimbley, “My Perspective on Bank Regulation,” Financial Engineering News, January-February 2007. In S. Bair, Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself, Free Press, 2012, the author, a former head of the U.S. FDIC criticized stridently the BCBS risk weights as well as the proposed policy to permit banks to construct models to determine minimum capital.

[6] “The Basel Committee is the primary global standard-setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters. Its mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability.” See http://www.bis.org/bcbs/about.htm . Conformance of national banking regulation with this “global standard-setter” is voluntary.

[7] Sometimes called “the central bank for the world’s central banks,” the mission of the BIS is “to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank for central banks.” See http://www.bis.org/about/index.htm?l=2 .

[8] See “The Supervisory Capital Assessment Program: Overview of Results,” Board of Governors of the Federal Reserve System, May 2009.

[9] See “Comprehensive Capital Analysis and Review: Objectives and Overview,” Board of Governors of the Federal Reserve System, March 2011.

[10] See “Dodd-Frank Act Stress Test 2014: Supervisory Stress Test Methodology and Results,” Board of Governors of the Federal Reserve System, March 2014.

[11] See K. Dowd, “Math Gone Mad,” CATO Institute 754, 1-64, September 3, 2014, for detailed and critical discussion of Fed and Dodd-Frank Act stress testing.

[12] See J. N. Feinman, “Reserve Requirements: History, Current Practice, and Potential Reform,” Federal Reserve Bulletin, 1993.

[13] A. Admati and M. Hellwig make this argument in The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It, Princeton University Press, 2013.

[14] See, for example, “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools,” Basel Committee on Banking Supervision, January 2013. We choose not to describe this proposal since it has no true conceptual advantage over the reserve requirement.

[15] See P. A McCoy, “The Moral Hazard Implications of Deposit Insurance: Theory and Evidence,” Seminar on Current Developments in Monetary and Financial Law, Washington, D.C., October 2006. In this article, the author notes U.S. President Franklin D. Roosevelt’s initial opposition to deposit insurance in 1933 prior to the later legislation of that year establishing the FDIC. Assessing U.S. bank failures in the 1980’s, McCoy writes: “As Roosevelt warned, deposit insurance gives rise to moral hazard, something that is endemic to all insurance programs.”

[16] As just one example, see “EU Senior Bank Creditors Face Losses as Parliament Votes,” Bloomberg News, April 15, 2014.

[17] “Lehman’s Fuld: Where was our bailout?,” Reuters, October 6, 2008.

[18] Id.

[19] See, for example, page 19 of “Part 2: The First Pillar – Minimum Capital Requirements,” Basel Committee of Banking Supervision. This page has a table showing 0% risk weights for the highest rated category of sovereign debt.

[20] See “Exclusive – ECB limits bond buying, eurozone looks to banks,” Reuters, December 9, 2011. Also see chapter 8 for a discussion of the ECB and LTRO.

[21] G. Morgenson and J. Rosner, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon, Time Books, 2011.

[22] C. W. Calomiris and S.H. Haber, Fragile by Design – The Political Origins of Banking Crises and Scarce Credit, Princeton University Press, 2014.

[23] Id.

[24] See, for example, K. Dowd, “Math Gone Mad,” CATO Institute 754, 1-64, September 3, 2014; J. Norberg, Financial Fiasco: How America’s Infatuation with Homeownership and Easy Money Created the Economic Crisis, Cato Institute, 2009; J. A. Allison, The Financial Crisis and the Free Market Cure, McGraw-Hill, 2013.

[25] See the Financial Crisis Inquiry Report, January 2011.


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Joe Pimbley
Joe is Principal of Maxwell Consulting, a firm he founded in 2010. Joe is expert in complex financial instruments, financial risk management (certified as FRM by the Global Association of Risk Professionals), valuation, structured products, derivatives, and quantitative algorithms. His recent and current engagements include financial risk management advisory, valuation and credit underwriting for structured and other financial instruments, and litigation testimony and consultation. In a prominent engagement from 2009 to 2010, Joe served as a lead investigator for the Examiner appointed by the Lehman bankruptcy court to resolve numerous issues pertaining to history’s largest bankruptcy. Joe and his colleagues discovered Repo 105 and also reported the critical importance of pledged collateral mishaps and mischaracterizations to the Lehman failure. Joe holds a Ph.D. in Theoretical Physics and is a co-author of Banking on Failure (2014), Simple Money (2013), and Advanced CMOS Process Technology (1989). He serves on several corporate and academic Boards, has written more than thirty finance articles, presented more than sixty finance seminars, and holds numerous patents for engineering inventions.
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