Thursday, 19 December 2013

Capital Arbitrage and BIS Risk Weightings

A recent article on VOX looked at some of the issues with risk weightings for bank regulatory capital under the revised BIS rules.

These rules require that assets with different perceived credit risk are valued differently for the purposes of determining a bank's minimum capital requirement.  Originally, the rules were very basic with assets falling into a small number of categories, with a different weighting assigned to each.  The system has now become much more complex, allowing detailed criteria against which each asset can be assessed.

One issue which has attracted much comment is the fact that banks are allowed to design their own criteria for determining risk weightings, known as the internal ratings based (IRB) approach.  Although the criteria have to be approved by the regulators, it is argued that they are not well placed to second guess the banks.  This is therefore likely to result in weaker criteria than would be designed by an outside party.

Another issue, more relevant to the VOX article, is capital arbitrage.  The problem here is that the actions of banks are not independent of the risk weighting criteria.  To some extent that's fine.  If banks choose to invest in safer assets on the basis that it has a lower capital requirement, then things are operating as intended.  The difficulty is that however detailed the criteria, they are merely a rough approximation of true risk.  There will always be an imperfect match with elements that don't fit well and it's those elements towards which business tends to gyrate.

A good way to illustrate this process is by looking at the world of asset-backed securities and ratings criteria.  When the ratings agents rate corporate borrowers, they assess the different companies as they are and decide the ratings.  Within any particular rating, there will therefore naturally be better and worse borrowers - some who are nearly at the next rating up and some who are barely above the rating below.

In rating asset-backed transactions, the rating agents use a set of criteria to determine what rating to give.  But now the game is different, because the structurer has the ability to design his transaction.  Improving credit risk costs money, so of the structurer's objective is to get away with as little credit enhancement as possible, whilst still achieving the desired rating.  In other words, he is always aiming for the very bottom of the range of credit risk for that rating.  And because the criteria are only really rules of thumb, that can mean a risk that is below what would normally be expected for that rating.

So, a similar issue can arise in banks that are subject to capital requirements based on a set of rules.  One aspect of this that was highly relevant to the financial crisis was the banking book / trading book distinction.  But the problem arises, albeit it in smaller way, even within the normal loan portfolio.  And making the rules more and more granular is unlikely to solve the problem in a practical way.  This is one of the main reasons why alternative capital requirements, such as the Leverage Ratio, are so important.


  1. I'm not convinced that maturity transformation doesn't in itself amount to a price distortion that damages the economy. So long as maturity transformation is happening, banks will be playing chicken -dicing with calamity. In principle couldn't we have a lending system that involved no maturity transformation. Savers could own bonds of the same duration as the loans made. If the bonds were typically held as ETFs then savers could draw down their savings by selling the ETF whenever they needed but with some interest rate risk. The loan companies could hold a capital buffer and if that was not enough to absorb losses, then the bond holders could have a debt to equity conversion so that they became the new share holders.
    Then debt financing would be on an equal footing with equity financing rather than having an unfair advantage. .
    The payment system could be totally separate from the lending system and the payment system could just be run like paypal (or like the mpesa mobile phone mediated payment system in Kenya).
    Our current system holds the payment system as a hostage so that reckless lenders can demand bailouts so as to preserve the payment system. We need to end that IMO.

  2. I guess my point above is that we could tinker with rules about capital requirements endlessly but basically banks as a concept perhaps need a fundamental rethink.

    We tolerate banks and bail them out because we think we can't do without them. But what if what they do is actually a counterproductive distortion? I get the impression that part of what drives support for banks is that they are profitable. But perhaps instead that very profitability should be viewed as being an administrative overhead on the real economy. No more than a waste; much like unnecessary bureaucracy.

    1. I'd agree that the payments system could be separated from lending activity, but I do think there is a place for bank-style maturity transformation alongside market-based maturity transformation. And whilst there is certainly scope for improving the functionality of the banking system, I think there will always be some kind of reliance on capital adequacy provisions. Adverse selection issues like that I have described will always arise, but that's life really. Regulators just have to be aware of it and work with it

    2. I'm interested in why maturity transformation (either by banks or shadow banks) helps the economy. I appreciate that it is something people currently seek but that doesn't mean it actually helps does it? I'm not even sure that credit would be much more expensive if their was a regulatory ban on maturity transformation. The instability of the current financial system causes distrust of long term debt securities issued by the finance industry. It is a vicious circle where long term funding is more expensive than short term funding due to fear of the roll over risk that comes from the maturity mismatch. Perhaps eliminating the mismatch would eliminate the distrust that necessitates the mismatch?
      The price fluctuations from long term treasury securities (eg 55year gilts) are viewed as a benefit for portfolio diversification. If we had a lending system without the (unnecessary) fragility of maturity transformation and where loans had to be held on the balance sheet of the original lender, then perhaps the long term bonds issued by such a lender would be similarly valued.

    3. Hypothetically if an insolvent lending company was dealt with by having a debt to equity conversion for the bond holders (a bail in), then wouldn't it primarily be the share holders who lost out? So if a lending company chose to have inadequate capital, then they would just end up gifting the company to the bond holders. Perhaps the fear of that is the best way to govern capital requirements.
      It is sort of taking the principle behind Alan Greenspan's (at the time misplaced) faith in the shareholders doing the regulation themselves. The big difference is that it is ensuring that the lending system is actually set up such that it is actually the shareholders (and then perhaps bondholders) who suffer all the losses rather than the tax payer bailing the system out.

    4. We don't have any regulations on the leverage ratios for say airlines or retailers do we after all. They can and often do go bust and because there is no need for a bailout, it is viewed as just the shareholders' own problem. Perhaps we simply need to ensure that the lending system is similarly self contained?

    5. Equity is obviously undated, but if I hold equity I can sell it. That is a form of maturity transformation. I think that is a good thing, because I think people would be less likely to make equity investments if they were never allowed to realise them. But that form of market based maturity transformation (which is how shadow banking works) is more prone to volatility than what regular banking does. At the very least it's different and in my view there is room for both.

      I think bank regulation is needed because banks are taking much more retail funding and it is generally harder to assess the quality of a bank's balance sheet without detailed information which is not publicly available. It is also part and parcel of having a banking licence and the operation of deposit protection.

    6. Nick, am I misunderstanding something? My understanding was that if a lender made a thirty year loan and funded that by selling a thirty year bond, then that would mean that no maturity transformation was taking place. The holders of those thirty year bonds could sell them on and that wouldn't engender financial fragility because someone was always holding them. There would be no maturity transformation; there would be no rollover risk.
      My understanding was that equity funding amounted to funding by selling a perpetual bond that paid out variable dividends depending on what the company could afford. The fact that shares can be sold at will between shareholders does not impact at all on the company that issued the shares. It is the form of funding that engenders the least financial fragility because the company never needs to obtain new funding to meet any obligations because there aren't any. Am I misunderstanding this?

      I previously tried posting about maturity transformation. I hope I wasn't in an utter muddle:

    7. The reason for deposit protection is because the lending system is tangled up with the payment system. If we disentangled them and had an m-pesa style payment system then we wouldn't have the payment system being held hostage.

    8. I thought that shadow banking amounted to say selling a series of thirty day bonds to fund a thirty year loan. It engenders rollover risk because as each thirty day bond comes to maturity, another one must be sold so as to pay back the principle on the first one and so on until finally at the end of the thirty years, the principle on the thirty year loan is received and the whole chain is settled. It all falls apart if at any stage no one offers to buy the next set of thirty day loans.
      Again I would be very grateful for any corrections if I'm muddled about this.

    9. Typical shadow bank maturity transformation works something like this. Long dated loans are repackaged into long-dated marketable securities. These are then held and funded by short dated repo, subject to daily mark-to-market and over-collateralisation. If the repo counterparty doesn't want to roll, the bonds are just sold.

      To be honest, I'm not sure that everyone would call this maturity transformation, as opposed to what banks do, but I think that's not a useful distinction and people do refer to shadow banks doing maturity transformation.

    10. Thanks for the explanation, I didn't realize that it typically had that form. BUT isn't the crucial point that the shadow banks HASN'T sold the long dated bonds and instead has chosen to hold onto them and fund them with the short dated repo? That is what creates the maturity transformation and consequent financial fragility. The shadow bank can't be sure that it will be able to sell the long dated bond for enough to pay back the repo-counterparty. That is how the shadow bank can throw up its hands and say that it needs a bailout or else it will pull down all the counterparties and cause a systemic collapse.
      I really want to try and understand this stuff because isn't a run on the shadow banking system the way that the 2008 collapse and bailouts came about?

    11. Nick, I just checked on wikipedia that I wasn't misunderstanding repo (that's my level I'm afraid). I do think I did understand it correctly. So as I thought, "a repo is equivalent to a spot sale combined with a forward contract". So my impression that the maturity transformation and the source of financial fragility is all from the "forward contract" part. The shadow bank can hope that it will be able to honor that forward contract but it is no more than a hope. It totally depends on either continued appetite of the repo market or being able to sell the bonds outright for enough. If both break down then it falls apart.
      Is the reason for doing this simply that funding is more expensive if the bonds are sold outright rather than being repo-ed throughout their life? Basically to me that demonstrates the "alchemy" of it in that the actual risk is not being paid for and instead is being borne by "the taxpayer" standing by to bail it out as and when that risk becomes realized.

  3. The problem with the way things are going is that there is an arms race between ever more sophisticated regulation and ever more sophisticated wriggling around the regulation. That means that only vast banks can compete. It basically is handing the privilege of oligopoly on a plate to the big banks.

    If there was an utterly basic, no-nonsense, set of rules such as no maturity transformation and all loans needing to stay on the balance sheet of the originating lender, then we could see real competition. The lenders that prevailed would be those that astutely assessed credit risk minimized costs -and that after all is what we want isn't it?

    1. Banks are becoming bigger, approaching the size of the central bank. Regulation is tighter, giving more control to the central bank.

      Central Banks are tightly tied to government, making either government in charge of the banks, OR, the banks in charge of government.

      Throw in fiat money, remove the discipline of gold backing. Then you can print money without limit. You can also give money to favored friends, and, you can bail out banks who make "imprudent" loans.

      Maybe we do NOT want to make responsible loans that will be repaid!

    2. Roger, I agree that if voters don't wrest back control, then the go-with-the-flow course could be towards bankers commandeering the state to effectively print off salaries and bonuses for the bankers. To me the worst effect would be if that was coupled with political efforts to cause an austerity driven deflation so as to maintain the real value of debt.

    3. It is an dilemma! The U.S. and world economy is "obviously" out-of-balance. Restoring balance and defining "balance" seems to be a difficult task.

      I finally took time to follow the links available here. I am looking forward to reading from your web site.

  4. Nick, have you seen Ashwin Parameswaran's post

    He used to be a banker and is also saying that maturity transformation is something we would be better off without.
    "Intermediaries that facilitate peer-to-peer (P2P) lending are subject to very little regulation in the United Kingdom (unlike the process of starting a bank which can take years and land you with a seven-figure legal bill). Unsurprisingly, there has been an explosion in the number of peer-to-peer lending platforms in the UK. Conventional wisdom would suggest that individuals who lend through such platforms would lend their money at higher rates than banks would. After all, they have nowhere near as privileged a position as banks do – no ability to create money ex nihilo, no access to the central bank’s repo window. But the reality is exactly the opposite. The lending rates in the industry are, if anything, too low. Individual lenders are falling over themselves to lend money to risky individuals and companies at rates far lower than what banks would lend to them at (to take just one example, take a look at the borrowing rates at Zopa).

    And P2P lending is not just a niche phenomenon – there are platforms that handle everything from invoice financing, bridge loans, longer-term loans to individuals and businesses and mortgages. The last couple of years have in effect given us a controlled experiment in what a non-maturity transforming lending system would look like. And the answer is that rates would be lower than they would be in a maturity-transforming system. Maturity-transforming banking is redundant – it only gives us recurrent financial crises. The idea that in the absence of bank maturity transformation, lending rates would explode has been disproven.

    This still doesn’t give us any answers as to what we can do to stimulate genuine disruptive and risky investment that can drag us out of the ‘great stagnation’. The answer is simple – we need to do more to promote equity investment in disruptive new enterprises. The conventional wisdom states that there isn’t enough risk appetite for all the equity financing that new high-risk businesses require for their investment needs. Again, the growth in equity crowd-funding is slowly disproving this myth"

    1. I had a look at that.

      Whilst, I think there is a place for P2P lending, just as I think there is a place for various other forms of finance beside mainstream banking, I cannot see it being anything other than a complement to banking, rather than replacing it.

      Furthermore, I wouldn't say that P2P avoids maturity transformation altogether. Zopa (referred to there) provides the facility for loans to be realised early by sale to other lenders (providing there are buyers). It's a different form, for sure, but that's still maturity transformation.

    2. Nick, isn't there a crucial difference between classic maturity transformation (where short term securities are sold to fund a long term loan) as compared to having a long term loan funded by selling maturity matched securities that nevertheless are liquid. The classic maturity transformation system risks a bank run if appetite for the short term securities dries up (as happened with Northern Rock). By contrast, funding by selling maturity matched (but nevertheless liquid) securities makes a bank run impossible. If the market looses faith in say 30 year bonds previously sold to fund 30 year mortgages, then the price of those bonds could fall BUT that is a risk born by the holders of those bonds. The lending company has no exposure to that risk. The lending company would have no cause ever to need a bail out.

      I know the "Positive Money" campaign wants to BOTH have maturity matched liabilities AND have those liabilities totally illiquid (by having a regulatory ban on owners selling them on) BUT to my mind they are asking for two quite separable changes. They are both wanting to eliminate the possibility of bank runs AND they are (IMO forlornly) hoping to prevent endogenous money. They are hoping to totally quench any "moneyness" of debt. Personally I think that second aim is totally futile as even illiquid saving accounts will inevitably act as money because if someone needs money and has a saving account maturing in say one years time, then they will themselves borrow knowing that they can afford to do so because they have the savings account maturing.
      To my mind the best system might be to have maturity matching but to do everything to make the debt securities as liquid as possible. So savers would hold say ETFs that held lots of bonds of a particular time to maturity. They could sell those at will in the secondary market if they wanted to draw down their savings and if everyone choose to do that at once, then they wouldn't get a good price BUT the lender would still be just as able to honor every liability and bailouts would be a thing of the past.

      Am I saying something incorrect? I'm not yet sure what you see as the likely downside.

  5. stone,

    There is certainly a difference between the way maturity transformation is carried out in banks and what shadow banking does. Nevertheless, they all rely in some way on the idea that the lender can get his money early, even if the borrower does not want to repay, because someone else will want to step in at that point. So they are all subject to the risk that in fact nobody wants to put their money in at that point. And this risk is one that is prone to panics. No-one will want to put their money in if they think that no-one else is going to put theirs in. The fact that any intermediary is matched and therefore bankruptcy remote doesn't avoid the scope for booms and crashes.

    I think there is a place for financing that relies simply on a secondary market to achieve maturity transformation. But you can't get away from the fact that it all relies on confidence in the system and the consequences of greed and fear. Maybe, I'll do a post on this.

  6. Nick, I totally agree with you that eliminating maturity mismatching would not prevent credit fueled asset bubbles and the crashes that those engender. I had a go doing a post that was also saying exactly that:
    But to my mind this isn't about cutting out credit risk, it is about ensuring that credit risk is sold on the basis that whoever is making a buck by supposedly taking on exposure to it, is actually fully exposed to all of the risk. If someone wants to hold debt securities that they actually view as being over priced, in the hope of selling them on to a greater fool, then that is their problem and they need to be fully exposed to the possibility that no greater fool is going to materialize, -just as if they had bought or stock in 2000 or Beanie Babies or Bitcoin or whatever.
    Also I think it is good to have the lending companies having a capital buffer to absorb much of the default risk but then if that is overwhelmed, to have a bail-in of the bond holders with a debt to equity conversion such that the bond holders become the new shareholders. Then the lending company would be very vigilant about ensuring that loans were only made that were likely to be repaid especially if all loans made had to be held on the balance sheet of the company that originally made the loan. That would mean that experts would actually be scrutinizing the loans as to the credit risk. IMO that expert assessment of credit risk seems to be the real societal service that "banking" ought to provide. They should perhaps do nothing more and nothing less.

    By the way, I think Wonga might be an interesting case. Wonga I guess is just a usurer providing a very dubious "service" (perhaps simply exploiting innumeracy of its clients). BUT it is funded in an exceptional way as far as I can make out in that it only has equity finance and it is a private company. So in the case of Wonga, the lenders are fully exposed. The financiers (such as the Wellcome Trust and Church of England) have an illiquid equity stake and the money they provided along with retained earnings is all that is used to fund the loans and pay for the administration, TV adverts etc.

    1. I suppose Wonga entirely funding its loans from equity is simply doing the same as small scale loan sharks have always done. The only difference is that Wonga is a multi-billion-pound company and uses algorithms to assess credit risk.

    2. The bubbles and crashes concern me because of the effect on demand. One of my recurrent themes has been the impact of credit risk appetite on aggregate demand, due to its role in the spending decision of credit constrained borrowers. My concern here would be that this type of finance is more subject to whim and fashion, so we would get waves of credit feast and famine.

      Again, I do think there is a place for it alongside traditional banking, but I'm not convinced that it would make sense to completely replace it. Things like P2P still represent only a small proportion of credit provision; if P2P funding suddenly dried up, it wouldn't be a big issue. That's not to say of course that we don't get traditional banking crisis as well, but on the whole I think it tends to be more consistent and it's easier for the central bank to manage.

      Worth noting as well that, in terms of credit supply, the recent crisis was less about traditional banking than about shadow banking - most of the huge variation in credit provision (which basically caused the recession) arose in shadow banking (see e.g. Gallin (2013) Shadow Banking and the Funding of the Nonfinancial Sector).

    3. Nick, what you are saying about the 2008 crisis being due to a run on the shadow banks fits in with what I had read about elsewhere too. I think maturity mismatched shadow banking is fragile just like conventional banking is. My worry about the fragility of conventional banking is just as true for maturity mismatched shadow banking. You describe how shadow banks typically package long term loans into long term bonds and then fund them by short term repo of those bonds. IMO they need to fund by selling those long term bonds outright so as to eliminate the fragility of maturity transformation.
      I totally agree that we need to be very concerned about bubbles and crashes but just because we can't eliminate them by eliminating maturity mismatching doesn't mean that eliminating maturity mismatching won't have benefits. I mean eliminating maturity mismatching won't solve every problem -we will still have soil erosion, religious intolerance etc :).
      To be honest IMO the lack of central bank involvement in setting interest rates in a maturity matched credit system might be a beneficial feature rather than being a problem. If the risk free rate was always at the zero bound, then all of the interest rate setting would be on the basis of credit risk. Isn't that allowing credit to be priced appropriately by the market?
      When you say that maturity matched credit could "completely dry up" are you meaning that the price of say 10year bonds for say funding small business loans would go to a crazy high real interest rate that would damage the economy? I (perhaps naively) think that panics occur when finance is disconnected from reality. If finance is never allowed to try and achieve alchemy and is always kept firmly grounded then that is the way to avoid panics. If a solid real business that is getting a good revenue stream is wanting a modest amount of credit, then is the market really going to forego the chance of lending to them in a transparent simple manner for a good return?

    4. Nick, when you say that maturity matched lending would be an erratic source of credit, I'm thinking that the yields for investment grade corporate bonds don't actually fluctuate wildly to a damaging extent do they? Isn't this all maturity matched lending would be? The supply of credit would be no more erratic than the yield for investment grade corporate bonds would it?

    5. Again, I'm not sure exactly what people understand maturity transformation to encompass. However, we can have one of two arrangements. First, we could have a position whereby any loan had to be held by the original lender until maturity. Imagine the loan being made directly by households, as there would be little role for intermediaries here. Lenders would also have to be prevented from borrowing for a shorter term than any loan they held. This is a world with no maturity transformation. Alternatively, we could allow households to sell their loan assets if they wished and we could allow pooling of assets with mixed maturities. Both of these are a form of maturity transformation (as I see it).

      I think lending would be much more limited in the former scenario. Furthermore, I think both types of maturity transformation (secondary market and pooling) have a place, although of course both involve risks. I'm not 100% convinced the benefits outweigh the downsides, but on the whole I think they do.

      I'm not that concerned about investment grade corporate paper actually, because those borrowers find it easy to borrow. The thing that causes variations in aggregate demand is loans to credit-constrained borrowers, i.e. those at the margin.

  7. To my mind booms and crashes might be symptomatic of their being an excess of paper claims over wealth as compared to the actually underlying real wealth (productive capacity I guess). Perhaps what is really needed is for crashes to effectively slough off that excess monetary value and so bring things back into balance. Basically to reset asset prices back to a lower value where the real earning potential of those assets dominates over the effect of random price fluctuations due to speculative "herd behavior" flows between asset classes.
    As such it is perhaps vital that crashes do actually write down monetary value without bailouts. The role of government perhaps should be to ensure that the economy can ride through such writedowns without the real economy becoming snarled up. I also had a go posting about that too