Wednesday, April 22, 2015

The amazing Achilles heels of the Basel Committee’s bank regulations

1. The unexpected losses (UL) are derived from the expected Probabilities of default (PD)

“It was decided… to require banks to hold capital against Unexpected Losses (UL) only. However, in order to preserve a prudent level of overall funds, banks have to demonstrate that they build adequate provisions against Expected Losses” (Page 7)

Under the implementation of the Asymptotic Single Risk Factor (ASRF) model used for Basel II, the sum of UL and EL for an exposure (i.e. its conditional expected loss) is equal to the product of a conditional PD and a “downturn” Loss Given Default (LGD) [a parameter that reflects adverse economic scenarios]. As discussed earlier, the conditional PD is derived by means of a supervisory mapping function that depends on the exposure’s average PD.

What does this mean? 

First, that the risk weights have nothing to do with the risk premiums banks charge. 

Second, the real dangerous unexpected losses in banking are most certainly inverse to the expected probabilities of default. The higher the expected losses the lower can we expect the probable size of the bank exposure to be… meaning, the safer an asset is perceived to be, the higher the possibilities of something really dangerous unexpected happening. In short this all does not make any sense.

Third, that this would not have been so serious if there had been an adjustment for portfolio risk, since most probably what is perceived as safe commands larger exposures...

but then, to top it up:

2. The risk weights are portfolio invariant... Holy Moly!

I cite directly from “An Explanatory Note on the Basel II IRB Risk Weight Functions” July 2005 (page 4) 

“The Basel risk weight functions used for the derivation of supervisory capital charges for Unexpected Losses (UL) are based on a specific model developed by the Basel Committee on Banking Supervision (cf. Gordy, 2003). The model specification was subject to an important restriction in order to fit supervisory needs: 

The model should be portfolio invariant, i.e. the capital required for any given loan should only depend on the risk of that loan and must not depend on the portfolio it is added to. This characteristic has been deemed vital in order to make the new IRB framework applicable to a wider range of countries and institutions. Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike. The desire for portfolio invariance, however, makes recognition of institution-specific diversification effects within the framework difficult: diversification effects would depend on how well a new loan fits into an existing portfolio. 

As a result the Revised Framework was calibrated to well diversified banks. Where a was calibrated to well diversified banks it is expected to address this under Pillar 2 of the framework. If a bank failed at this, supervisors would have to take action under the supervisory review process (pillar 2). 

What does this mean? 

That the benefits of diversification are completely ignored... that the risk weights have nothing to do with the size of the exposure… all because to consider diversification, that “would have been a too complex task for most banks and supervisors alike”, and so “the Revised Framework was calibrated to well diversified banks.” 

But, if a bank fail to be well diversified, then the supervisors, those who have just been deemed as not being able to understand what diversification is, shall address the problem under Pillar 2 of the framework, the “Supervisory Review Process.” Basel II (page 158) 

And if all that does not sound like sheer Kafkaesque lunacy, you tell me. 

As a result we then have portfolio invariant credit-risk-based equity requirements, which allow banks to hold less equity against safe assets than against risky assets, even though all major bank crises in history have never ever resulted from excessive exposures to what was perceived as risky, but always from excessive exposures to what ex ante was perceived as safe.

And that led to much lower equity requirements for what ex ante is perceived safe than for what is perceived risky.

And that caused banks to be able to leverage much more their equity, and the support society gives them, with assets ex ante perceived as safe than with assets perceived as risky.

And that caused banks to be able to generate much higher risk adjusted returns on equity with assets ex ante perceived as safe than with assets perceived as risky.

And that meant that banks would lend too much and at too easy terms to those perceived as safe, like to "infallible sovereigns" and the AAArisktocracy, and too little in relative too harsh terms, to those perceived as risky, like to SMEs and entrepreneurs.

With bank regulators like these… who need enemies?

And please read the Explanatory Note and consider what a regular subordinated regulator would dare to opine about it :-)

PS. Risk of cyber-attack weighted equity requirements for banks make much more sense than the credit-risk weighted