February 26, 2014

Basel 3: A Solution or A Challenge?

Too put it simplistically, the capital structure of an enterprise is determined by preference for the level of debt versus equity. It depends on whether the enterprise is more risk-averse or rather risk loving. In the latter case, it would prefer a higher degree of debt. Of course, cost motives also play a role.
Now in the case of a bank, capital structure is not purely driven by preferences. In determining the level of equity and debt, banks have to fulfill certain requirements put forward by the government. Banks have a vital role in the economy, namely facilitating spending and investment. If a bank would go bankrupt, it has far-reaching implications, affecting millions of people. This we have seen with the recent financial crisis. Thus the governments try to prevent the worst-case-scenario from happening. However globalization came up along the way. These days, banks are active across national borders. This raises the need for international regulation with respect to the banking system.
This need was answered by the development of Basel Committee on Bank Supervision. This is an international advisory authority on bank regulation, raising issues critical to the health of the banking system. The Basel Committee has developed capital adequacy standards that national regulators can implement, named the Basel Accords. The accords all address the need for bank capital regulation. This means that they request rules that require banks to hold certain levels of capital.
With the financial crisis of 2008, the Basel Committee on Banking Supervision found an opportunity to restructure the approach to risk and regulation in the financial industry. They developed the Basel 3 framework to augment the framework of Basel 2 in 2010. In 2013, the European Union implemented the Basel 3 agreements in the EU legal framework. The primary goal is to improve the ability of banks to absorb asset losses without affecting the whole economy. Next it aims to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector. Below you can find a breakdown of the Basel 3 proposals in order to achieve these objectives.

So we have pointed out that Basel 3 is a very recent accord. Nevertheless a lot of criticism has been formed and the potential impacts have been researched extensively. We will set out here a summary of the impact on the individual banks and on the financial system as a whole. 

Impact on individual banks
-Reduction in competition
-Pressure on profitability and ROE
-Increase in long-term funding
-Increase in group reorganizations

Impact on financial system
-Reduction in risk of individual bank failure
-Reduction in lending capacity
-Reduction in investors' willingness to invest in bank debt or equity
-Room for arbitrage when Basel 3 is implemented internationally in different ways

We briefly illustrate the points made above. Starting at the top, weak banks will find it harder to raise the required capital, leading to a reduction in competition. Next the need to reorganize and deal with regulatory reform puts pressure on the margins. The two liquidity ratios in Basel 3 focus on short-term and long-term liquidity and funding will drive firms away from short-term funding. Finally, increased supervisory will lead to a reorganization of groups. Now we are at the impact on the financial system. An increased buffer in capital and liquidity should reduce the risk of bank failure. Further increase in capital and liquidity regulation may lead to a reduction in capacity for banking activity. ROE and profitability of banks decrease so there is less room for dividends. Finally, international regulatory arbitrage may remain to disturb the stability of the financial system.

"In the EU we are noticing that there is a credit crunch that you would not normally expect in a more positive economic environment. So, while consumer confidence is increasing, OEMs' ability to keep up with this demand may soon diminish as working capital reserves are exhausted and banks resist lending due to the ongoing overhaul of the European banking system.. Though full implementation of Basel III is not expected in the EU until 2018, it already appears to be influencing banks' credit strategies."

  1. Basel 3: Issues and Implications - Report of KPMG
  2. Implementing Basel 3 in Europe - European Banking Authority
  3. EBN

February 24, 2014

Is more financial stability possible?

The RoE (Return on Equity), an internal performance measure of shareholder value was a wrong financial performance measure. Since RoE is the most well-known performance indicator widely used by market participants and banks themselves in their disclosures (i.e. at the top line of bank reports), targeting RoE has exposed banks to higher unexpected risk levels and opened the door to a more shortterm- oriented approach to balance sheet management. This ratio was not adjusted for the risks that financial institutions are taking, i.e. leverage funding and liquidity profile.
Policies, including Basel I, have encouraged regulatory arbitrage. Reduced capital ratio minimums incentivized banks to increase leverage and a significant reduction in reserve requirements in the 1990s, precipitated lower liquidity and higher leverage. This created the conditions for a financial crisis we are facing today.

In the years 2002–06 before the crisis, profits were high but several large banks required bailouts. Banks increased profits through both balance sheet and off-balance-sheet growth and by taking on riskier asset/liability mismatches.

1. Return on Equity (RoE):
Return on Equity is the primary measure banks have pursued to evaluate their performance. RoE used to be very convenient for bankers. The bank board was given a target RoE which they could achieve in one or two ways: they could increase the returns or hold the equity low in the RoE measures. In the banking business they did both at the same time, high returns and equity low.

     RoE = net income / average total equity

Since mid-90’s the banking sector was underperforming the utility sector and was not serving the investors very well. It has bankers let to keep equity to a minimum and made them vulnerable as enterprises and has made the whole financial system very fragile.
What are proper ways to value the banks? What are the measures bank management and investors should be focusing on?
If bankers continue to pursue the target RoE they should wait for a longer period of years of time to measure if they have hit the target or not and to reward themselves. If they don’t wait this period for the consequences of the risks taking with the equity they are given. Than they need to adopt intra measures that are risk adjusted.

2. Return on Assets (RoA):

Return on Assets (RoA) is a basic measure of bank profitability that corrects for the size of the bank.

     RoA =   net income / average total assets

3. Return on Risk-Weighted Assets (RoRWA):

By introducing the measure Return on Risk-Weighted Assets (RoRWA) the boards and executive management needs to focus on the issue of risks. What risks are banks taking, what order of magnitude, what are the potential outcomes, in which area. These risk weights come out of Basel regulations, exposure against which they are measured are generated by the banks themselves. Since the crisis there are new Basel regulations, Basel III which is an improved version of Basel II/2.5. Now also capital and liquidity requirements, including the Tier I capital leverage ratio, liquidity coverage ratio, and the net stable funding ratio are primary measures of a bank.

But are these Basel-driven risk weightings right? Does a bank board need to judge these weightings themselves? Which other measures do we need to take into account to let banks better perform than in the past? The RoE was the primary measure of many banks which they pursued in terms of the profitability objective, the capacity to generate sustainable profitability. We have seen that it has not contributed to long-term shareholder value. Instead it has contributed to volatility of returns, excessive leverage, risk-taking which has made our financial system very unstable. This has encouraged the banks to keep the equity small as possible and the leverage as large as possible and has made the financial system fragile. Today, it is very important to promote financial stability. We have to create well regulated banks that are more prudent. It means more equity in the mix and having the right targets to encourage them.

We are investigating how the RoE changed before, during and after the crisis. What are the main drivers explaining the RoE changes over the crisis? What are appropriate performance measures after the financial crisis? Are the Basel regulations good policies or do need banks themselves consider other measures. Are stress testing programs imposed by Basel a good tool to supplement other risk management approaches and measures?

References :

  1. The determinants of bank capital structure. Working Paper Series. No 1096 / September 2009. European Central Bank.
  2. Beyond RoE - How to measure bank performance. September 2010. European Central Bank.

February 16, 2014

Life after a Catastrophe

By definition, in a fractional reserve banking system, banks use high leverages. Nevertheless criticism about the capital structure of banking sector and its risks expressed after every major financial crisis and bank run; and 2008 global financial crisis was not an exception. We all hear the call to deleveraging and the frightening stories about how excessive use of leverage in banking industry lead to not just an unstable financial system, but also a fragile economy as a whole. 

In this blog we will examine these claims and look at the effects of 2008 global financial crisis to the balance sheets of banking sector. We will mainly focus on the European countries. Since the debt crisis in Europe is still an issue, we believe that a deeper investigation would be beneficial for everybody with an interest about the situation of European financial system. 

One of the main mistakes that we see in both the layman’s and most of the financial press’ perception of Europe is the tendency to look at these countries as consisting of two very different groups. Namely: the rich north and the poor south. They then expect an alignment in every issue according to this binary paradigm.  
In the case of usage of leverage in banking sector among different European countries, this story of bi-polarity is simply refuted and we see that the reality is a lot more complicated. The chart below shows how leverage ratios vary among countries. It also shows that deleveraging after the financial crisis is not ubiquitous and there is a significant variation among countries.  

Moreover we’re observing a significant change in the lending behavior of banks after the financial crisis. The chart below shows that banks lend increasingly more to governments instead of households or private firms. There are various reasons for this situation, which I will not investigate further in this article, but I believe that simply by looking at these figures we can talk about a crowding out effect.

We're not just observing a change in the balance sheets of the banks but also their activities itself. Today, Banks are not the traditional banks that we know of. Deposit & lending is just a fraction of their business. Shadow banking and capital markets have been increasingly substituting their role as lenders. 

An op-ed article at the Wall Street Journal by AXEL WEBER and SERGIO ERMOTTI also point at this matter and criticizes the naive focus on leverage ratios:
“There are two ways banks can increase capital ratios: either by increasing capital or by reducing risk-weighted assets (RWAs). A recent paper by the European Banking Authority shows that the Core Tier 1 ratio for 64 EU banks rose to 11.7% in June 2013 from 10% in December 2011. This improvement has come fairly evenly from banks both increasing capital and reducing RWAs.
Within that reduction of risk-weighted assets, there has been an implicit incentive for banks to shift away from capital-intensive corporate lending to less capital-intensive activities, such as lending to governments. 
Weak bank lending has been somewhat offset by capital-market activity. The problem is that bank lending still makes up 80% of corporates' total funding mix. Moreover, although debt issuance is an option for large listed companies with reasonable credit ratings, it is not a viable form of financing for smaller companies—let alone individuals.”

As they also point out, because of the riskiness difference among assets, the importance of leverage ratio becomes questionable. With the Basel 3 standards we will see some interesting developments about this issue.

There is a lot to say and we will try to investigate these issues further in our future posts.  

References :
  1. The Wilder View - The European Debt Crisis In 3 Charts 
  2. The 'Silent Austerity' in Banking by AXEL WEBER and SERGIO ERMOTTI

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