Perspective on Risk - Oct. 9, 2023
More on the Future of the Financial System; BIS Rpt on the 2023 banking turmoil; Capital Rules For Insurers; Bowman; Fed SPVs? Housing Thought; Arbitrage or Compliance; Consultants; Wirecard
More on the Future of the Financial System
I forgot to add this to the last Perspectives. The BIS Quarterly had a section Unpacking international banks' deposit funding
Netting out interbank lending and abstracting from the effect of central bank quantitative tightening, we find that during the banking turmoil in the first quarter of 2023 the source of banks' deposit funding rotated from the non-financial sector to non-bank financial institutions. This rotation was material in a handful of jurisdictions. In particular, residents of Switzerland moved deposits from international banks located there to domestically oriented banks. Dollar funding of banks in the United States shifted to money market funds, which then increased their (repo) dollar funding of non-US banks.
The Post-mortem Navel Gazing Never Stops
The BIS has weighed in with Report on the 2023 banking turmoil. All of the things we have discussed before on risk management, bank supervision, and regulatory standards.
Liquidity
This paper has a reasonable laymans discussion of the liquidity developments at each institution. Box A shows how much of an outlier SVB’s deposit withdrawals were, and shows how they compare to the LCR assumptions.
SVB was an outlier; writing regulations based on outliers is bad practice
Looking Forward
The thing to do when reading these analysis for the BIS is to see where the emphasis is (and isn’t) as clues to their forward work. Section 3 has an interesting preliminary discussion of how the specific features of the Basel liquidity framework have performed, interest rate risk in the banking book, the definition of capital, and the degree of implementation of BIS-level expectations.
Liquidity
Extensive section; clearly the primary area of supervisory focus:
The experience with CS at an entity level raises doubts about the operationalisation of the HQLA buffer needed to meet LCR requirements. A large part of CS’ HQLA held to meet its minimum LCR requirement was reserved for purposes other than to cover the outflows in a 30day stress scenario as foreseen in the LCR framework. For example, CS set aside HQLA to cover daily operational and intraday liquidity needs. This raises issues about the design and operationalisation of liquidity requirements.
A related issue is the calibration of the LCR. In the case of CS, during a severe stress event, a large part of its Pillar 1 LCR requirement was needed to cover daily operational/intraday liquidity needs – which are not covered by the LCR – instead of potential outflows over the envisaged 30-day horizon, which raises questions about the design of the LCR, including the scope of risks captured. In a similar vein, the speed and scale of deposit outflows for the distressed banks suggests that banks may not always be able to rely on an extended (eg 30-day) window of time to address their liquidity problems.
Another question raised by the turmoil is whether the NSFR performed its role as an indicator of banks’ structural liquidity mismatch, particularly for banks that faced a “slower burn” liquidity stress.
Another perspective is that existing liquidity standards are adequate, and that the focus should be on their effective implementation. For example, the operational requirements for HQLA in the LCR standard already consider the issue of buffer availability at a consolidated level and note the potential of intraday liquidity needs.
There is definitely a bias here towards more work.
Interest Rate Risk
The discussion of interest rate risk in the banking book is comparatively sparse.
One perspective is that an appropriate implementation of the Committee’s IRRBB standard can adequately mitigate the risks faced by banks by enabling timely and effective actions from authorities.
Another perspective is that the current Pillar 2/3 approach does not adequately mitigate such risks. … This view notes that the current framework can lead to vastly different outcomes, with some jurisdictions applying capital add-ons across their banks while others having no such add-ons irrespective of duration risks, as a suggestion of the shortcomings of the Pillar 2/3 approach.
The last sentence is the Europeans tweaking the US, which long advocated (as I have discussed in earlier Perspectives) that this was an area the US did not want to touch in the capital discussions. I see no change here, at least until the US decides to implement something here.
Definition of Capital
The first issue is whether the treatment of unrealised gains and losses for assets that are HTM should be similar to those that are held as AFS.
The second, related, issue is whether HTM assets should be eligible as HQLA for the purpose of the LCR and NSFR.
Another perspective is that such a move could have potentially far-reaching structural consequences for banks’ balance sheets and business models, as it would lead to an increase in the volatility and procyclicality of prudential capital, not only in the event of unrealised capital losses but also in the event of unrealised capital gains.
The juice here is in this last sentence. There is always a debate about how market-sensitive the regulatory capital regime should be. The UK and the Fed tended towards a more market based approach (at least in the past), but to be fair even in the US there was no firm consensus here.
The argument is that banks did not need to be mark-to-market animals because they had access to funding due to the government guarantee (when banks were funded with insured deposits) and access to the discount window (when that was a bank exclusive). The trend here is towards MTM, but things like the presence of the notional-based bank term funding facility by the Fed is a step towards recognizing that full MTM may not be desireable.
Recent events have shown that investors and markets did not fully internalise the various trigger events that could lead to loss participation of AT1 instruments, even though the Basel Framework contains explicit language on those trigger events and Pillar 3 disclosure requirements, and despite contractual documentation clearly highlighting the corresponding risk factors of such instruments. In addition, the fact that CS continued to make expensive replacement issuances to avoid negative signalling effects and to pay a substantial amount of discretionary interest on these instruments (alongside dividend payments for common shares), despite the fact that it was reporting losses over several consecutive quarters, raises questions about the ability of such instruments to absorb losses on a going-concern basis.
Again, there is a continuing trend towards higher quality capital. Prior to the GFC, the quality of capital was very poor, and hence the leverage on actually equity was quite high. This will be revisited, tightened, and fought by the banks the entire way.
Application of the Basel Framework
The Basel Framework applies on a consolidated basis to internationally active banks. It does not define the concept of internationally active banks. … recent events have shown, however, the failure of a bank can have systemic implications through multiple channels, including first- and second- round propagation effects.
Remember, from a Basel perspective, SVB was an internationally active bank as it had a London subsidiary.
The Committee’s high-level considerations on proportionality – while informative in nature and not binding – provide guidance in this respect as they call for an equal treatment of the same type of risks irrespective of the type of institution. … The turmoil raises questions about whether the design of proportionality frameworks can impede effective supervision by reducing standards, increasing complexity and promoting a less assertive supervisory approach.
Again, a bit of a shot at the US for not adequately supervising SVB, Signature and Republic. This goes nowhere.
The distress of CS showed that a bank may comfortably meet regulatory requirements (eg the LCR) at a consolidated group level, while encountering more difficulties at a standalone legal entity level. In principle, the sum of standalone legal entity requirements can be much larger than a group’s requirement, which suggests the minimum LCR requirements calculated at the consolidated group level can (significantly) overestimate the liquidity risk resilience of legal entities
One perspective is that there may be merit to continue to reflect on the potential regulatory implications stemming from the recent turmoil on approaches pursued to the allocation of capital and liquidity within banking groups.
This is the Brits arguing to support entity-level supervision and requirements. This again is settled; supervisors in individual jurisdictions are going to do what they believe is needed to protect their depositors and economies.
Capital Rules For Insurers
Federal Reserve Finalizes Its Rule
The Fed currently supervises six (6) insurance holding companies because these six qualify as S&L Holding Companies. Federal Reserve Board finalizes a rule establishing capital requirements for insurers supervised by the Board.
The Fed has adopted the Building Block Approach (BBA), whereby the available capital and required capital of a top-tier company in an SIO is aggregated with those of its subsidiaries, as determined according to each subsidiary’s applicable capital framework.
The minimum ratio required capital is 250% and the capital buffer has been reduced to 150% rather than the 235% proposed in the NPR. The minimum capital requirement under the BBA would be 400% (analogous to 10.5 % of risk-weighted assets under the banking capital rule).
This basically gives the insurance industry everything it was asking for.
But Fed. Gov. Bowman Objects to Degree of Delegation to Staff
This is something I’ve never seen. Statement by Michelle W. Bowman on the Final Rule for Insurance Company Capital Requirements and the Associated Delegation of Authority.
I cannot support the delegation of authority to staff. I am concerned that today's package includes a broad delegation of authority to staff to make a range of determinations about the application of the rule. The Board has not had the opportunity to consider specific cases in which such authority would be exercised, and it would be more appropriate to provide specific parameters around the use of delegated authority in the context of an actual determination. When the Board delegates authority to staff, such delegations should also expressly provide that staff is not permitted to act on any matters that raise significant legal, policy, or supervisory concerns. Including appropriate parameters around the use of delegated authority is important to support the values of transparency, fairness, and accountability.
Not the first time Bowman has made waves. You’ll remember from Perspective on Risk - May 15, 2023 where I discussed a speech where she took shots at Quarles and Barr., and Perspective on Risk - May 22, 2023 where she was arguing against further regulation.
Meanwhile, Bank of England Relaxes Solvency Rules for Insurers
Back at the end of June, the Bank issued The PRA consults on major elements of the new Solvency UK framework, with measures to simplify the framework, improve flexibility, and support growth and competitiveness
The Prudential Regulation Authority (PRA) is consulting today on a major set of reforms to Solvency II with the aim of creating a new UK regulatory regime for insurance firms, known as Solvency UK, which is better adapted to the UK insurance market. The proposals include further streamlining of reporting requirements for all firms and substantially simplifying and improving the flexibility in the assessment of internal models.
And Announced Plans For An Insurance Stress Test in 2025
PRA statement on the dynamic general insurance stress test in 2025. Key phrase highlighted below.
The PRA intends to run a dynamic general insurance stress test in 2025.
The objectives of the exercise will be to:
assess the industry’s solvency and liquidity resilience to a specific adverse scenario;
assess the effectiveness of insurers’ risk management and management actions following an adverse scenario; and
inform the Prudential Regulator Authority's (PRA) supervisory response following a market-wide adverse scenario.
The dynamic nature of the 2025 exercise represents a significant change from previous exercises and will involve simulating a sequential set of adverse events over a short period of time. Consequently, the PRA intends to engage with the industry including trade bodies over the next six months, with a view to providing more details of this exercise (including participation, design, and timelines) during the first half of 2024.
More Bowman
Brief Remarks on the Economy and Insights from Past Bank Regulatory Reform Efforts.
I would like to revisit a few of the regulatory actions the Board has engaged in over the past year. I will identify several lessons we can learn from these actions and consider how we can apply these lessons when thinking about ongoing and future reforms to the bank regulatory framework.
Specifically, I would like to address three broad themes: (1) how efficiency should be a key factor in policy discussions, (2) how to think about limits on the Board's tools to implement policy decisions, and (3) the importance of due process and public engagement in rulemaking.
Before the Board uses its regulatory or supervisory authority, we need to ask a basic question: Does the Board have the legal authority to use the tool in the manner contemplated? Late last year, the Board published principles for climate-related financial risk management for large financial institutions for public comment.
Such narrow and specific guidance runs the risk of going beyond the scope of safety and soundness, by focusing on narrow, remote and uncertain risks with minimal demonstrated impacts on financial institutions.
Another example I want to highlight is the use of conditions in applications. In the process of deliberating on applications that come before the Board, the Board can impose limitations or restrictions in certain circumstances, to address specific supervisory or policy concerns raised by the application. While this can be an important tool, it cannot replace rulemaking.
Finally, I want to talk about how due process and promoting public engagement can improve the rulemaking process, including by helping policymakers understand the impact of proposed rules.
In October of last year, the agencies finalized amendments to the Board's Regulation II, implementing new rules pertaining to debit card routing on different networks. During the public comment process, community banks raised substantial concerns with the proposal, specifically around the uncertainty of the rule revisions on fraud and the cost of compliance. As a result of comments raised, and my view that significant questions remained about the effect of the rule, I did not support the Board's final action.
Why Does The Fed Use SPVs?
Steven Kelly of Yale with a thorough discussion. Why Does the Fed Really Use SPVs?
Reputable discussion of the Fed’s use of SPVs—from journalistic coverage to legal articles to governmental reports—often take as received wisdom that the Fed sets up these vehicles to evade its legal limitations. However, the Fed itself has never said this anywhere. Indeed, the Fed’s communications surrounding its SPV interventions have mentioned the creation of SPVs without offering a justification.
A comprehensive look at the Fed’s history with SPVs reveals the oft-postulated story of legal evasion does not hold up. For one, the Fed’s history with SPV use and non-use is not consistent with that story. Additionally, formerly confidential internal documents from the time of the GFC lay out the Fed’s thinking and make clear it analyzed the use of SPVs within the bounds of its authorities.
I’m not going to steal his thunder. Click over and read; it’s quite good (and correct IMO).
Random Housing Thought
Supply of housing is down, property prices are high. So why isn’t the Fed accelerating the winddown of its MBS holdings? Shouldn’t the relative cost of buying be increased relative to building?
Arbitrage or Compliance
Consultants
Santander ditched EY as financial crime consultant over alleged failings (FT)
EY agreed to terminate a consulting contract and refund millions of pounds to Santander’s UK business after failings in its anti-financial crime work for the bank, according to three people with knowledge of the matter.
The quality of work performed by EY was so poor that the professional services giant was forced this year to offer the bank a refund of about £15mn for the project, the people said.
The UK’s Financial Conduct Authority in December fined Santander £108mn, one of its largest penalties for anti-money laundering processes, for failings between 2012 and 2017.
Remember Wirecard?
I love this scandal. I’ve written about it here. Latest from Der Spiegel:
Fugitive ex-Wirecard executive is said to be involved in Russian espionage operation
While German police are still searching for the suspected fraudster, British investigators are making serious allegations against ex-Wirecard board member Marsalek: He is said to be behind a Russian espionage operation.