By Karamjeet Paul (Published by American Banker/BankThink September 25, 2014)
The financial services industry is often caught in a debate about whether it faces too much regulation or not nearly enough. This is a valid topic of discussion. But it distracts from another, even more critical matter: regulations in the aftermath of the most recent financial crisis have failed to effectively address the root problem that caused so many bank failures.
The big news this week is that large banks will be required to have a higher level of capital in the form of a surcharge amount of capital.
The Wall Street Journal reported on September 9, 2014 (“Fed to Hit Bog Banks With Stiffer Surcharge”) that the new requirements are “aimed at reducing the risk …” and the required increase in capital would be “calibrated to the relative riskiness of the bank as measured by a series of factors.”
Large banks, or may be most banks, may very well need more capital. But this need for capital has not been tied directly to what causes the need for capital in the first place. Some of these “series of factors” aren’t necessarily a measure of what creates the capital requirement.
Capital is needed to cushion unexpected losses arising from extreme-tail risk, which carries the exposure that can result in devastations in extreme crisis. Therefore, the amount of the capital need should be driven by an explicit measure of extreme-tail risk. Unless an objective and transparent measure of extreme risk is used, proposals often lead to the use of factors that are not necessarily connected to extreme risk.
An example, as reported by the WSJ: “One new wrinkle in the Fed’s plan is to tie the size of the surcharge to a bank’s reliance on short-term financing …” The use of short-term financing creates liquidity risk, which matters in a crisis only if extreme-tail risk is perceived to be excessive. It doesn’t create extreme-tail risk. So a surcharge for this factor will have no bearing to the need for capital to deal with extreme risk in crises.
Unless, extreme-tail risk is addressed explicitly, a higher amount of capital will not accomplish what the Fed is trying to do. According to William Coen, Secretary General of the Basel Committee on Banking Supervision, “The answer isn’t simply to say you need another X basis points in capital. Maybe the better response is to require the bank to present a detailed plan on how it’s going to better manage these risks and to make sure the bank sticks to that plan.”
The debate about capital adequacy in the banking industry is not new. Those who have been in the industry long enough know that it has been around for at least 30-40 years. To date, the industry has resisted any change to the status quo, with a result that in the post-2008 world, regulators will define the needed change using subjective measures and opinions backed by the Dodd-Frank Act provisions. Such an approach will actually make banks more vulnerable than stronger in crises.
Lets face it. The status quo, as rationalized currently, is unacceptable. So either the capital requirement has to change or a new rationalization is needed. Rather than fighting or struggling to cope with the regulatory proposal, the industry must proactively come up with an objective approach to capital adequacy rationale that gets to the root of the problem.
I believe the use of an objective and simple measure like “Probable Maximum Loss,” along with an explicit focus on extreme-tail risk, can bring objectivity to this discussion and help make banks and the financial system stronger. As part of the suggestion by Mr. Coen, regulators should insist, and institutions on their own should develop effective plans for extreme-tail risk.
By Karamjeet Paul (Published by Forbes September 22, 2014)
With banks getting ready for the year-end regulatory stress testing, it is worth looking at what stress testing is and, more importantly, what it is not.
Typically, stress-testing models simulate adverse conditions to evaluate if a system/structure can survive abnormal circumstances. For banks, the objective of regulatory stress testing, also known as Comprehensive Capital Analysis and Review (CCAR), is “to assess whether the largest bank holding companies operating in the United States have sufficient capital to continue operations throughout times of economic and financial stress …”
Passing CCAR is important as low grades create a negative perception and accompany regulatory restrictions. However, passing stress tests can also create a false sense of security because of what it is not.
By Karamjeet Paul
Those calling for higher capital requirements for banks have the right objective of making financial institutions and the system stronger (everybody agrees with that objective). However, their proposals to increase capital don’t receive support from everyone because their approach is not a proven one.
In a New York Times article on August 10, 2014, “When She Talk, Banks Shudder,” Prof. Anat Admati of Stanford University was quoted as offering an analogy of what’s wrong with banks today: “My comparison is to speed limits. Basically what we have here is the market has decided nobody else should be driving faster than 70 miles an hour and these are the biggest trucks with the most explosive cargo and they are driving at almost 100 miles an hour.”
Perspectives on Sustainability of Financial Institutions In Financial Crises
reflections on regulation, law and public policy
Karamjeet Paul
Sustainability Management 