capital requirement

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The Current Approach to Management of Risk Will Always Fall Short

Posted by Karamjeet Paul on October 22, 2014
Posted in: Extreme-Tail Risk, Regulations. Tagged: , , , , . 1 Comment

Yesterday’s Wall Street Journal carried a story: “Fed Tells Banks to Shape Up or Break Up.”. Even though the story does not specifically talk about the financial risk, it implies that banks are not doing enough to address regulators’ concerns. And addressing risk has been a significant concern since 2008. So if you combine it with their concerns that bank models almost always understate their capital requirements, it leads to a lack of trust and confidence, and may be even to mistrust.

Even if banks do all they can, there will always be a confidence gap because the current approach to managing risk can never cover the entire spectrum of risk. The problem arises because no one knows nor can define how much of the risk spectrum is not covered. And as long as there is an uncovered portion of the spectrum, banks are vulnerable. Such vulnerabilities will come to light only when the next crisis arises. Combined with the fact that risk models are too complex to follow and understand easily, there is no way to tell if the portion of the spectrum that is addressed has been done correctly or effectively. Thus banks are not only vulnerable but also no one knows how vulnerable, and whether this vulnerability is acceptable. This is the root cause of the confidence gap.

What is needed is a transparent approach that addresses the entire spectrum of risk that can be easily grasped. (See “What Stress Testing is Not”). Until this is addressed, the current approach to risk will always fall short and there will remain a confidence gap.

Plans to Address Extreme-tail Risk Are More Effective Than a Capital Surcharge

Posted by Karamjeet Paul on September 10, 2014
Posted in: Capital, Regulations. Tagged: , , , , , , , , . Leave a comment

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.