In this excellent Bloomberg article Matt Levine makes fun of BofA’s latest accounting error, making it necessary to revoke its planned return of shareholder funds. The bank had proudly announced its capital return programme only weeks before with – and now it gets funny – explicit consent of the regulator. The reason for the change was evidence of double counting of profits/losses stemming from decreases/increases in the Bank’s creditworthiness (yes, you read that correctly: under current accounting standards banks are allowed to book a profit whenever they get less creditworthy). Click the link to get the full article:
There are a few points I take away from this article:
1.) Our regulatory/accounting rules for banks are that complex that (literally) dozen of people at the bank and the regulator got it wrong
2.) The moral hazard problem with bank management is as prevalent as it has ever been
3.) The accounting rules, by targeting false precision, conflict with purposes of regulation
In order to keep the post short, I will comment on the first point, with the rest to follow in future posts:
Complexity through over-regulation
Currently Banks are still obliged to follow Basel II rules, but required to perform and disclose additional Information to what extent they currently meet future Basel III requirements. Under Basel III Banks will either have to hold more capital for the same risks (e.g. trading book) and hold capital for risks that so far have not had to be accounted for (e.g. liquidity risk a.s.o.). All in all, under Basel III banks will be required to hold more capital and comply with more rules. So far so good, but here is the problem: both, the implementation date as well as the rules, are subject to constant change. There are many reasons for this, some good, some bad. For example, there is clearly constant lobbying of banks to water down the rules and postpone implementation. You can bet they are very effective as they are in a position to threaten the government (regulator) – always preoccupied with some election and hence fearful of recessions – with a credit crunch or a lack of buyers for the respective sovereign debt. Some of the rules have been hastily implemented and don’t necessarily make sense, punishing one type of bank disproportionately more than others (e.g. treatment of minority shareholders in regulatory bank capital). And last but not least, different regulatory objectives between the US and Europe which culminate in whether the leverage ratio should treat derivatives as they are treated under US-Gaap (Net) or IFRS (Gross). As everyone knows: it is difficult to agree on the right strategy if the objective is unclear!
Now, as a mental exercise, let’s put ourselves into the shoes of a regulator assessing a bank’s budget in the year 2014: apart from the stress test assumptions which are always subject to discussion, the regulator has to decide whether to base his assessment on current requirements (Basel II) or to include, in a forward-looking way, potential future Basel III requirements. The difference is non-trivial: If he wants to include them, which makes sense, he/she is faced with the problem of how to weight the information and with the question on which legal grounds he/she can enforce action on a private enterprise? Enforcing future regulatory requirements today is tricky from a legal perspective, likely requiring further by-laws and the like, effectively resulting in what Ludwig von Mises called a “Interventionsspirale”, i.e. once triggered, market interventions (regulations) make further interventions necessary. As one can imagine, there is plenty room for haggling and backdoor deals between the regulator and bank management and its lawyers. Consequently, there is inconsistent treatment between banks and across countries, only increasing the confusion. Matt Levine probably has good reason to suspect double standards being applied between Citigroup and BofA. There is simply no way to be consistent!!!
Complexity through Internal Models and conflict of interest
Basel III is an extension of Basel II, i.e. its goal is to have risk assessed, not by some objective rule, as under Basel I where you had prescribed risk weights, but according to internal bank models. I remember when back at university our professors, who had a knack for financial models, spoke admiringly of Basel II. Banks, they said, after all knew best what risks they have and how to measure them (their principal agent and moral hazard models they showed us in another, unrelated lecture). Well since the financial crisis, for obvious reasons, nobody would argue that way anymore. So today one hears a different argument: “well, we know models are not perfect, but it’s the best we have at the moment”. Really? As the following graph charts show, banks have used the leeway provided by internal models mainly to reduce risk-weights (i.e. lever up their balance sheets). The chart in the lower right corner is especially informative, as it compares risk weight under the old (Basel I) approach to those applied by British banks under Basel II.
The results speak for themselves: in every segment the Basel I approach (green) puts a higher weight on risk exposures than the internally modelled one. This result implies that for the average bank portfolio, an 8 percent risk-weight, i.e. more than 12 x leverage, is way, way too conservative. Clearly, managements’ desire to lever up the balance sheet have had an influence on the risk models chosen – the power of incentives at work.
The regulators answer to this state of affairs is typical for our times: instead of replacing a failed methodology as it is based on wrong principles (bank self-assessment) one just pops up further, supportive regulation thereby adding to complexity in disproportional way. Under Basel III there will be a myriad of-add-ons regulators have to apply to the bank’s risk weights on a discretionary basis, if they suspect that they are not conservative enough. Welcome to the world of arbitrary, costly and difficult to enforce regulation!
In my next post I will touch the issue of moral hazard in banking!