Sunday, September 23, 2012

Why Bank Regulators Should NOW SCRAP Basel Norms

Basel-III: The norms are not suited for emerging world banking --Published in ET on 

24 SEP, 2012, 06.30AM IST, 

Alok Sheel

There are fundamental differences between financial systems in advanced market economies (AMEs) and those in emerging market and developing economies (EMDEs). These differences, inter alia, explain why financial intermediation held up relatively well in these economies even as financial markets froze in AMEs during the recent global financial crisis. 

The biggest difference is that AMEs have increasingly moved towards reliance on short-term money and capital markets for funding, and 'money created' against volatile financial assets and innovative products exchanged over the counter ('shadow banking'). EMDEs, however, continue to be dependent on more stable deposit-based funding. This difference is critical. 

Financial systems in both EMDEs and AMEs become vulnerable during downturns in the business cycle on account of deterioration in asset quality. Ever since deposit insurance was put in place following the banking panic during the Great Depression, deposit-based banking is no longer susceptible to funding risks arising from financial panics and bank runs. 

As long as their capital is calibrated to cover asset quality deterioration during business downturns, EMDE banks no longer face major funding risks other than a general decline in financial savings, as long as external currency-denominated deposits are kept within prudent limits through capital controls. 

AMEs are, in addition, exposed to funding risks arising from financial panic characteristic of build up of leverage in capital markets. This vulnerability has increased following the repeal in 1999 of the Great Depression-era Glass-Steagall Act in the US that drew a firewall between deposit-based banks and those (investment banks) that rely on capital markets. 

Basel-II banking capital norms were calibrated to cover risks arising out of traditional deposit-based banking. They were not designed to cover funding risks emanating from sharp maturity mismatches and attendant difficulties in rolling over credit on account of financial panic that can result in rapid deleveraging, credit freeze and a breakdown in financial intermediation. 

Financial panic has in some way or the other always been preceded by a considerable rise in leverage. The primary drivers of leverage in AMEs and EMDEs are strikingly different. Increasing leverage in AMEs in the period leading up to the global financial crisis was an attempt to increase returns on capital in an environment of low returns. 

High credit growth in EMDEs, like India, on the other hand, was primarily to finance high rates of growth and investment in the real economy. The returns on capital in EMDEs are now significantly higher, as a result of which global production has long been migrating to these countries. 

There was, of course, also speculative investment in certain asset classes, but margins on such credit were incrementally raised in response to the rising pace of credit expansion through conservative macro prudential financial regulation. This is a defining characteristic of EMDEs like India, where regulators have not hesitated to spot and prick asset bubbles, rather than simply waiting to clean up after they burst. 

Following the recent global financial crisis, a slew of financial regulatory reforms are being contemplated under the aegis of the G20, Financial Stability Board (FSB), the Basel Committee on Banking Supervision (BCBS) and other standards-setting agencies to protect the integrity of financial intermediation. 

Are these headed in the right direction? EMDEs clearly need to increase financial savings to accelerate growth and development, notwithstanding the fact that in recent years, capital was flowing uphill from EMDEs to AMEs. This was arguably a temporary and unsustainable phenomenon that may be about to change as theglobal economy rebalances. 

AMEs, on the other hand, need major regulatory changes that inoculate them more effectively against the risks their financial system face, and also roll back some of the more extreme forms of financialisation that exposes them to greater risk in the first place without commensurate impact on growth. 

While financial regulatory reforms are expected to be implemented across all jurisdictions, the immediate impact of most would be felt acutely in the relatively lightly-regulated AMEs, rather than in the more tightly-regulated EMDEs. The impact of the new Basel-III banking capital adequacy norms, however, will be almost equal across both AMEs and EMDEs even though the nature of risks in their financial systems is quite different.
Basel discord
Levelling bank playing field just got jostled
Daniel Indiviglio / Sep 20, 2012, 00:30 IST (Business Standard )

The worldwide playing field for banks had been levelling but just got jostled. One of America’s top regulators said on Friday the Basel III accord should be scrapped. Thomas Hoenig, vice-chairman of the Federal Deposit Insurance Corp, urged adoption of a simpler, stricter leverage ratio. A year after Jamie Dimon called the new worldwide global capital standards anti-American, the latest sign of resistance will only stoke fears about the US commitment to new rules.

The former president of the Kansas City Federal Reserve Bank joined the anti-complexity bandwagon. Hoenig contends that the 1,000 pages of capital rules introduce even more unwanted complications into an already overcomplicated bank supervision regime. Just last month, Andy Haldane, from the Bank of England, argued much the same against the “Tower of Basel.”

Hoenig wants banks judged on a more straightforward ratio of tangible equity to tangible assets. That would get rid of imperfect risk ratings. In his somewhat radical and belated plan, however, Hoenig first would need retail banks to shed their investment banking arms. Even that wouldn’t necessarily make them safer, though. A leverage ratio also can be gamed. To maximise returns, lenders could still load up on high-yielding but risky assets.

The quest for simplicity is understandable. Hoenig, however, in his speech honed in on Basel without factoring in other initiatives like living wills and the Volcker Rule designed to protect the system. More likely, and concerning, is that US bank executives, regulators and policymakers will latch on to his broader conclusion: that if Basel III isn’t revisited, the United States should refuse to implement it.

The rest of the world has already been pretty worried about that scenario. After leading much of the charge on the Basel II accord, signed eight years ago, the United States was slow to embrace it. Most US officials have been making the right sounds about Basel III. Dimon and other bank bosses also aren’t likely to sign up quickly for Hoenig’s ratios either. Financial institutions and authorities globally needn’t fear the worst about regulatory arbitrage just yet, but they’re right to remain wary.
How to lose weight fast the Deutsche Bank way
Jonathan Weil / Sep 24, 2012, 00:03 IST
Business Standard
Imagine if I told you I could reduce my own body weight by 80 per cent or more, on paper, through a series of calculations utilizing my own proprietary mathematical models, the details of which are so complex and highly prized that I couldn’t divulge them.

You would be right not to believe me, and might think I’m nuts. Yet this, in essence, is what regulators let banks do all the time with their balance sheets. Huge swaths of assets are allowed to vanish, making too-big-to-fail financial institutions seem leaner and safer than they are.

 Under the system known as risk weighting, banks get away with this because they are allowed to stipulate that some assets carry little, if any, risk. Many government bonds, for instance, fall into the riskless category for purposes of determining regulatory-capital ratios. So a bank can assume it won’t incur losses on them, which allows it to keep a lower capital cushion. The flaw here is that rulemakers aren’t good at predicting what kinds of assets might blow up. Some governments, especially in Europe, are in awful shape and pose a real risk of defaulting.

In other words, the notion of risk weighting is a farce, at least the way it is practiced now. Yet it carries the imprimatur of the Basel Committee on Banking Supervision, the Swiss body that writes capital standards for most of the developed world. Thankfully, a US regulator has stepped up to say the world should scrap the Basel committee’s standards.

Speaking out

The American speaking out against the latest Basel proposal is Thomas Hoenig, the former head of the Federal Reserve Bank of Kansas City who now sits on the Federal Deposit Insurance Corp.’s board. And to see why he is right to do so, take a look at Germany’s largest bank, Deutsche Bank AG.

Deutsche Bank had $2.84 trillion of assets on its June 30 balance sheet, which was prepared using the International Accounting Standards Board’s rules. Yet the company said it had only 372.6 billion euros of risk-weighted assets. That’s the figure it used to come up with a 10.2 per cent capital ratio for regulatory purposes.

So, somehow Deutsche Bank made 83 per cent of its assets disappear, which really is all you need to know to realize that the whole Basel construct is a sham. More than three-quarters of Deutsche Bank’s total assets consist of securities, loans and derivative instruments, all of them carrying varying degrees of risk. Yet the much smaller risk-weighted figure would have us believe that the bulk of Deutsche Bank’s assets were riskless, which obviously can’t be true.

There’s no way to tell from the company’s latest report to investors how Deutsche Bank got this figure, except we know some asset classes, such as sovereign debt, are deemed much less risky by Basel rules than other kinds of assets, such as plain- vanilla loans. The Basel rules let the largest banks rely on their own proprietary models to determine how risky their assets are. The latest revisions proposed by the Basel committee, which span several hundred pages, wouldn’t change that.

In a September 14 speech, Hoenig said the better way to assess capital adequacy is to develop a rule that is simple and enforceable. “It should reflect the firm’s ability to absorb loss in good times and in crisis,” he said.
“It should be one that the public and shareholders can understand, that directors can monitor, that management cannot easily game, and that bank supervisors can enforce.” And it “should result in a bank having capital that approximates what the market would require” if no government safety net were in place, Hoenig said.

Capital ratios

The measure that best achieves those goals, he said, is a capital ratio that divides a bank’s tangible equity by tangible assets. Tangible equity would start with shareholder equity and exclude all intangible assets (such as goodwill), which are worthless in a crisis. Hoenig also would exclude deferred tax assets; profitable companies can use these to reduce their tax bills, but they are worthless to companies going broke. Hoenig said a reasonable capital ratio would be 10 per cent or higher, depending on examiners’ findings at a given bank.
Deutsche Bank would look much weaker by this measure, mainly because the assets in the calculation would be about six times as large. Its capital ratio under Hoenig’s formula would be 1.4 per cent. That translates into leverage of about 70-to-1.

Because of differences in how derivatives are treated under international accounting standards, Deutsche Bank’s reported assets probably would drop by about half if the bank used US generally accepted accounting principles. Likewise, its capital ratio under Hoenig’s way would be higher using US GAAP numbers, but nowhere near 10 per cent.
Hoenig’s proposal has weak spots. Arguably, a 10 per cent minimum isn’t high enough. And the contents of banks’ assets and liabilities wouldn’t be any more transparent than they are now. US banking regulators, including the FDIC and the Federal Reserve, are in the process of adopting their version of the latest Basel proposals, known as Basel III.
At least under Hoenig’s idea we would move away from a system that is designed to breed excessive leverage. And we would get regulators out of the business of guessing which assets are safe and which aren’t. It’s worth a shot.
Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own
Swiss investors shun Indian papers on downgrade fears
Rising swap costs pull down Swiss bond issuances
Somasroy Chakraborty / Kolkata Sep 20, 2012, 00:28 IST
Switzerland could soon lose its status as the preferred destination for Indian companies raising funds abroad.

The lack of interest by Swiss investors for Indian papers, as well as the rising swap cost, is discouraging Indian firms from raising money in Swiss francs (CHF), merchant bankers told Business Standard.

 “For the time being, issuances are not happening in Swiss franc because of this whole overhang of potential downgrade in India’s rating. This is because many of these investors are now not allowed to invest in sub-investment grade papers. They will have to compulsorily sell the bonds if India’s rating downgrade happens,” said Sunil Agarwal, head of institutional client group at Deutsche Bank in India.

According to him, the swap cost for converting the Swiss franc into the dollar is not favourable. He says the swap cost is one of the factors responsible for the decline in Swiss bond issuances this calendar year.

When Indian issuers raise funds in a foreign currency, they usually prefer to convert it into the dollars because of its universal acceptance.

Bankers said of the 19 foreign bond issuances this year, only two were in Swiss francs. Even these two transactions happened before rating agencies such as Standard & Poor’s warned of a possible downgrade in India’s sovereign rating.
Indian corporates and financial institutions have been raising funds from Swiss investors since early 2011. Between January 2011 and March 2012, they have mopped up over $1 billion by selling bonds in Swiss francs.

“Since March 2012, no issuances have happened in Swiss franc. I believe the primary reason is the cost of conversion into dollars. The fear (among Swiss investors) of rating downgrade is a bit overplayed. I expect sentiments to improve in the coming months,” said a senior banker with a foreign bank on condition of anonymity because he was not authorised to speak to the media.

Some bankers and economists expressed optimism that India’s rating downgrade may not be imminent following the barrage of reform measures announced by the government.

“We believe the risk of a rating downgrade is now immensely reduced and the government could have bought itself time till at least the next Union budget,” Indranil Pan, chief economist at Kotak Mahindra Bank, wrote in his note to clients last week.

However, experts feel investors will not be keen to put their money into Indian papers until the uncertainty is lifted.

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