Monday, December 28, 2009

Playing by the (Basel) Rules

US private debt grew from 20 trillion dollars in 2000 to over 50 trillion dollars in 2007, but FDIC regulated banks (referred to as banks for the rest of the discussion) continued to stay "well capitalized" during this period. How could total debt grow by 80% without leading to the deterioration of bank's capital?

To answer this question, we need to look at how banks are regulated. At the end of 1980s, the G-10 countries decided to coordinate their banking regulation through the Basel Committee on Banking Supervision of the Bank for International Settlements (B.I.S.) by setting capital adequacy requirements. According to the Basel rules, all banks and depository institutions in the countries that adhered to them must maintain a certain minimum fixed amount of capital in relation to its assets.

The capital adequacy requirement set by B.I.S is to protect the banks from unexpected losses, since the banks are protected by expected losses by accounting for them on their books. The term "capital" might give you the impression that it is cash held by the banks in their vaults. But such a usage is misleading. Generally speaking, capital is the portion of bank's assets that don't have to returned to creditors (depositors are also creditors). It is only because of the fact that this portion of its financing does not have to be repaid that the bank has the capacity to withstand unexpected losses. It is the capital that absorbs these unexpected losses. The Basel rules classify capital into 2 tiers - Tier 1 "core" capital and Tier 2 capital. Tier 1 capital largely consists of funds raised through selling common stock, disclosed reserves, and retained earnings. Tier 2 is defined as undisclosed reserves, revaluation reserves, loan-loss reserves, convertible bonds, cumulative preferred shares, and subordinated debt.

The Basel rules require that the banks hold certain minimum ratios of clearly defined capital (calculated at book values) against assets that are adjusted by clearly defined weights.

Capital ratio = Capital / Risk-weighted Assets

Under this framework, banks to be considered "capitalized" are required to hold no less than 8 percent capital against total risk-weighted assets.

The system of assigning weights to assets is fairly standardized requiring minimal supplementation by various national banking regulators. In the United States some of the risk weighting rules are as follows (for details look at BIS 1988):

  • 0% weight to cash, gold, and bonds issued Organization for Economic Co-operation and Development (OECD) governments

  • 20% risk weight for AAA and AA rated asset-backed securities and claims on OECD banks, local public-sector entities, and agencies of OECD governments, such as the government sponsored enterprises Fannie Mae and Freddie Mac.

  • 50% risk weight to mortgage loans

  • 100% risk weight to all claims on the private sector and non-OECD governments, to investments in real estate, equities, corporate bonds, and all other assets rated lower than AA

In addition to the Basel rules, the FDIC in the United States require that banks aspiring to be deemed "well capitalized" - and thus enjoy valuable privileges like securities underwriting - must hold their capital in a configuration that meets additional three additonal ratios: capital to risk-weighted assets of 10 percent, tier-1 capital to risk-weighted assets of 6%, and tier-1 capital to total assets of 5%. The chart above plots these three ratios for American FDIC banks leading upto the financial crisis. It should strike you that, as per the Basel rules, banks were a few percentage points higher than those mandated by FDIC for being "well capitalized". This might seem hard to square with the expansion of indebtedness that took places during the credit boom years.

The regulatory ratios can be achieved by either increasing the numerator or by decreasing the denominator - by building up capital, or by cutting back on lending or reducing the riskiness of the balance sheet. But, with the credit boom underway, neither might seem feasible. But in fact, both methods were used extensively, which led to the impression of a financial system that was safer than it really was.

To illustrate the kind of games that the banks played, lets use an example offered by Robert Merton:

If a bank were managing and holding mortgages on houses, it would have to maintain a capital requirement of 4%. If, instead, it were to continue to operate in the mortgage market in terms of origination and servicing, but sells the mortgages and uses the proceeds to buy U.S. government bonds, then under the BIS rules, the US government bonds produce no capital requirements and the bank would thus have no capital maintainance. However, the bank could continue to receive the economic equivalent of holding mortgages by entering into an amortizing swap in which the bank receives the total return on mortgages, including the amortizing features and prepayments, and pays the return on US Treasury bonds to the swap counterparty. The net of that series of transactions is that the bank receives the return on mortgages as if it had directly invested in them. However, the BIS capital rules, instead of being 4 percent, apprears to produce a capital requirement using the swap route of only 0.5 percent.

Central to this example is the active management of a bank's balance sheet by selling and swapping assets through securitization. Playing this game is also called as regulatory arbitrage - restructuring a bank's portfolio so that it has the same or even greater risk as before, but a lower capital requirement.

It is costly to maintain capital - it lowers the profitability of the bank and constraints its growth. Thus, it is in the bank's interest to not hold mortgages on its books, but to transfer the mortgages to a securitizer such as Fannie Mae or Bear Stearns or "hide" it in its shadow bank conduit, freeing up the its capital. The freed up capital can either be used to pay down its debt (not what happened during the credit boom) or to expand its balance sheet by making more loans (what happened during the credit boom).

This is how banks continued to appear well capitalized and not reflect the economic reality of an indebted economy

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