Friday, December 18, 2009

BIS Reforms Grind One Step Closer

Original posted on the PrefBlog:

The Bank for International Settlements has released a consultative document titled Strengthening the resilience of the banking sector, which fleshes out some of the proposals made when the granted most of Treasury’s wish list immediately prior to the last G-20 meeting.

Naturally, the regulators gloss over their own responsibility for the crisis:

One of the main reasons the economic and financial crisis became so severe was that the banking sectors of many countries had built up excessive on- and off-balance sheet leverage. This was accompanied by a gradual erosion of the level and quality of the capital base. At the same time, many banks were holding insufficient liquidity buffers. The banking system therefore was not able to absorb the resulting systemic trading and credit losses nor could it cope with the reintermediation of large off-balance sheet exposures that had built up in the shadow banking system. The crisis was further amplified by a procyclical deleveraging process and by the interconnectedness of systemic institutions through an array of complex transactions. During the most severe episode of the crisis, the market lost confidence in the solvency and liquidity of many banking institutions. The weaknesses in the banking sector were transmitted to the rest of the financial system and the real economy, resulting in a massive contraction of liquidity and credit availability. Ultimately the public sector had to step in with unprecedented injections of liquidity, capital support and guarantees, exposing the taxpayer to large losses.

They emphasize their disdain for Innovative Tier 1 Capital, which has been reflected in the ratings agencies evaluations:

The remainder of the Tier 1 capital base must be comprised of instruments that are subordinated, have fully discretionary noncumulative dividends or coupons and have neither a maturity date nor an incentive to redeem. Innovative hybrid capital instruments with an incentive to redeem through features like step-up clauses, currently limited to 15% of the Tier 1 capital base, will be phased out.

Due to conflicts with the legislation to outlaw income trusts, Canadian IT1C may be cumulative-in-preferred-shares and has a maturity date. It will be most interesting to see how that works out.

Of particular interest is:

The Committee intends to discuss specific proposals at its July 2010 meeting on the role of convertibility, including as a possible entry criterion for Tier 1 and/or Tier 2 to ensure loss absorbency, and on the role of contingent and convertible capital more generally both within the regulatory capital minimum and as buffers.

Contingent Capital is discussed regularly on PrefBlog - I don’t think it’s a matter of “if”, but “when”.

One part is simply crazy:

To address the systemic risk arising from the interconnectedness of banks and other financial institutions through the derivatives markets, the Committee is supporting the efforts of the Committee on Payments and Settlement Systems to establish strong standards for central counterparties and exchanges. Banks’ collateral and mark-to-market exposures to central counterparties meeting these strict criteria will qualify for a zero percent risk weight.

A centralized institution will never fail, eh? I guess that’s because it will never, ever, do any favours for politically well-connected firms, and Iceland was the last sovereign default EVER. I think I know where the next crisis is coming from.

There is also a section on liquidity management, but it does not address a key fault of the Basel II regime: that banks holdings of other banks’ paper is risk-weighted according to the credit of the sovereign supervisor. This ensures that problems accellerate once they start - it’s like holding your unemployment contingency fund in your employer’s stock.

Let us suppose that ABC Corp. issues $1-million in paper to Bank A. Bank A finances by selling some of its paper to Bank B. Bank B has an incentive - due to risk-weighting - to buy Bank A’s paper rather than ABC’s, which makes very little sense.

They’ve finally figured out that step-ups are pretend-maturities:

“Innovative” features such as step-ups, which over time have eroded the quality of Tier 1, will be phased out. The use of call options on Tier 1 capital will be subject to strict governance arrangements which ensure that the issuing bank is not expected to exercise a call on a capital instrument unless it is in its own economic interest to do so. Payments on Tier 1 instruments will also be considered a distribution of earnings under the capital conservation buffer proposal (see Section II.4.c.). This will improve their loss absorbency on a going concern basis by increasing the likelihood that dividends and coupons will be cancelled in times of stress.

Their emphasis on “strict governance” in the above is not credible. They had all the authority they wanted during the crisis to announce that no bank considered to be at risk - or no banks at all - would not be granted permission to redeem. Instead, they rubber-stamped all the pro-forma requests for permission, making it virtually impossible for banks to act in an economically sane fashion (as Deutsche Bank found out). It’s the supervisors who need to clean up their act on this one, not the banks.

I’m pleased by the following statement:

All elements above are net of regulatory adjustments and are subject to the following restrictions:
• Common Equity, Tier 1 Capital and Total Capital must always exceed explicit minima of x%, y% and z% of risk-weighted assets, respectively, to be calibrated following the impact assessment.
• The predominant form of Tier 1 Capital must be Common Equity

I am tempted to refer to the Common Equity ratio as “Tier Zero Capital”, but I have already used that moniker for pre-funded deposit insurance.

Their list of “Criteria for inclusion in Tier 1 Additional Going Concern Capital” is of immense interest, since this will include preferred shares:

8. Dividends/coupons must be paid out of distributable items

11. Instruments classified as liabilities must have principal loss absorption through either
(i) conversion to common shares at an objective pre-specified trigger point or (ii) a
write-down mechanism which allocates losses to the instrument at a pre-specified
trigger point. The write-down will have the following effects:
a. Reduce the claim of the instrument in liquidation;
b. Reduce the amount re-paid when a call is exercised; and
c. Partially or fully reduce coupon/dividend payments on the instrument.

Regretably, they do not provide a definition of “distributable items”. I suspect that this means that preferred dividends may not be considered return of capital and that they must come out of non-negative retained earnings, but it’s not clear.

One interesting thing is:

Minority interest will not be eligible for inclusion in the Common Equity component of Tier 1.

The next quotation has direct impact on Citigroup, particularly:

Deferred tax assets which rely on future profitability of the bank to be realised should be deducted from the Common Equity component of Tier 1. The amount of such assets net of deferred tax liabilities should be deducted.

All in all, the document has a certain amount of high-level interest, but the real meat is yet to come.

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