European bankers are caught up in a debate over whether to disclose their full supervisory capital demands to market participants. That’s an issue because bank supervisors, under Pillar 2 of the Basel III accord, can set a bank’s regulatory capital “guidance” at a level higher than its Pillar 1 “requirements.” Bank analysts and investors can discount the securities of banks with relatively high guidance, assuming that supervisors have learned something negative in their confidential reviews. That’s the essence of Pillar 3: Market Discipline.
Financial reporters and investors are in favor of full disclosure for both capital requirements, as well as Pillar 2 guidelines. “Markets operate best with greater transparency,” asserted an editor in the January 31, 2017 issue of Global Capital. “There is simply no need for banks to let the size of their capital buffers become a subject for speculation when they have the option to publish all of their supervisory capital demands.”
At least some legislators also support the release of more information underlying the regulatory capital metrics. For example, Conservative Party MP Andrew Tyrie has urged the Bank of England to disclose more about the internal risk models of large UK banks.
“The market mechanism for imposing good behaviour on banks might work better, possibly much better. Its manifest shortcomings were brutally exposed in the crash,” argues Mr. Tyrie, whose views were cited in the Financial Times of June 7, 2016.  “The case for greater disclosure is now strengthened, not weakened, by the greatly increased intrusiveness and complexity of the supervisory process and of financial regulation.”
Regulators and supervisors have resisted calls for more disclosure of specifics. Bankers are uncertain, at least based on the disclosure evidence cited by the FT. That may be a function of the fact that Pillar 2 can only be capital accretive, not reductive. Yet, bankers should be firm supporters of universal disclosure – for the reasons that we explain below.
- What if banks were to get a capital benefit from investing in superior risk management technology – and if that benefit was disclosed to the market?
There is no explicit credit in the regulatory capital accord for banks which offer superior risk-management services. Presumably, supervisors invoking Pillar 2 of the Basel Accord can take that into consideration, although at present they cannot adjust capital buffers below the minimum requirements. That’s not fair to banks that have invested heavily in systems to control their risk exposures.
Case Study: Securities Finance
Banks lend securities while offering indemnification against borrower default to their institutional and corporate customers. Currently, the weight of new capital regulations is forcing banks to price the indemnification beyond customers’ ability to pay. As a result, the availability of securities to lend is expected to drop by as much as 50% in the next five years, potentially leading to impaired pricing efficiency in markets and higher risks for investors.
If supervisors were willing to accept the relative strength of an agent bank’s risk management systems and if Pillar 2 could be used to reduce a superior risk manager’s capital requirements, then it could be argued that lender indemnification for some agent lending programs should be exempted from the capital regulations or fractionalized in some way. (Similar arguments with different metrics could help borrowers with their own regulations, especially the net stable funding ratio.) That would be a huge incentive for banks to invest in the best possible risk management technology.
There is a solid logical basis to argue for regulatory capital relief resulting from superior risk management technology. There is also strong evidence to believe that banks would seek that relief, rather than repeal of Dodd-Frank regulations, based on the enormous post-crisis investment that banks have made in risk management and compliance systems.
According to one senior banker, “Agent lenders have made great strides in mitigating the perceived risks in securities lending especially in terms of cash reinvestment where most of the problems occurred during the financial crisis. We focus on liquidity, concentration risks, diversity, as well as appropriateness of haircuts, collateral type, the mix of collateral – it goes on and on.”
That level of risk management is a big investment for any bank. But it’s not being considered as an offset against such capital impositions as the counterparty concentration limit, the leverage ratio, or other metrics that force capital to be reserved against off-balance sheet risks.
- Should not the merits of risk management investments be disclosed and their costs partly repaid by taxpayers in the form of capital relief?
Supervisors should have the ability to reduce the capital requirements for banks with above-average risk management systems in their business lines. What does that mean in specific terms? Let’s look at one example:
Discussion: In securities finance, agent banks currently hold collateral against the securities that are loaned out for their customers. The agents’ risk management systems mark the collateral to market prices each day, but the details of the process can differ among banks. Sometimes the differences are subtle, visible only when comparing contractual commitments among agent banks. Perhaps a benchmark should be devised to show those differences – not to rate the contracts of individual customers, certainly, but to reveal an average for the bank itself, which may be kept confidential by supervisors, and, for all banks, as an information release to the public market.
Initial haircuts on collateral in securities lending may be standard, depending on the form, but the point can vary at which additional margin is demanded of the borrowers. Conceivably, any bank which allows collateral margins to fall below 100%, all else equal, would be taking more risk to offer its default indemnity. However, that bank might be in an excellent position to judge the exposure to its counterparty, more so than a universal statistic. Conversely, banks might be seen to take less risk when maintaining margins above the average. That adds protection against a taxpayer bailout, ultimately, but such a policy is also likely to make loans of easy-to-borrow securities less attractive to borrowers.
(These examples are merely illustrative to help consider options “outside the box” for regulatory capital reform. It may be far too difficult to collect the required metrics, compute the benchmarks and then analyze the results to be practical. Yet there must be a better system than the one that currently has resulted in so many unintended consequences. )
- Why don’t capital rules allow for a reduction in risk-weighted capital requirements, to help offset the lost revenue and encourage more conservative collateral management?
Customer income and bank fees will fall if borrowers consistently avoid banks which enforce tough collateral margins. Still, that income drop is a normal risk-return outcome, well understood by customers and their bank relationship managers.
Discussion: In another example from securities finance, the trading desks of agent lenders generally hold a loan buffer that prevents the distribution of the total inventory of available positions in a securities issue. That’s useful in the case of a loan recall, when the customer has sold its position and needs the borrowed securities back to make delivery. The buffer allows the agent bank to substitute another lender’s position, thereby obviating the need to close out the loan and return the borrower’s collateral. Buffers are clearly risk mitigants, since excessive recalls by lenders during a crisis would force the return of cash collateral and possibly lead to fire sales of longer-dated instruments. The buffers protect the taxpayer, but there’s an obvious opportunity cost to the customer and the bank that holds a substantial buffer. Fear of cascading fire sales is at the heart of the securities finance regulation, but none of these dynamics are currently being considered either in the details of the capital regulations or in the data collection process itself.
At present, the data aggregation process of global supervisors is focused on levels and loans. There’s very little data on collateral management, buffer maintenance or other dynamic metrics. But now may be the time to change that, along with a revision of the capital regulations. Banks that disclose the efficiency of their investments in risk-mitigating technology should be granted not only a market premium on their securities, but also consideration in relation to their capital requirements (and guidelines).
- Dynamic metrics are far more relevant for understanding the levels of stability in securities finance than are static sizing and demographics alone.
There’s no question that the time is right for an enlightened construct to revise/replace the current macroprudential framework. In a January 31, 2017 letter to Federal Reserve Board Chair Janet Yellen, the House Republicans announced “a comprehensive review of past agreements that unfairly penalized the American financial systems in areas as varied as bank capital, insurance, derivatives, systemic risk, and asset management.”
There's more than one way to approach systemic risk mitigation so why not try capital relief and disclosure?