Flaws In Bank Capital Models, Revisited

We saw a little sunlight on shadow banking back in 2010. But it transpires things went a little dark again for a while and, hey presto! Our banks may be holding insufficient capital. 

The latest burst of sunlight - at least for us mere mortals - came yesterday in two posts by FT Alphaville - one on 'BISTRO-style' high-cost credit protection transfer deals done by banks during 2010, and the other on how the FSA has responded.

But this is not about sub-prime malarkey, and the risk of mis-pricing towers of CDOs. This is about banks trying to reduce the amount of capital they need to hold for regulatory purposes to guard against failure... and getting it wrong to the point that it "could become systemic". 

Apparently, the banks strike deals with unregulated shadow banks which attempt to "...structure the premiums and fees so as to receive favourable risk-based capital treatment in the short term and defer recognition of losses over an extended period, without meaningful risk mitigation or transfer of risk... The underlying assets that have been used in these securitised deals include leveraged loans, loans to small and medium-sized enterprises and even books of derivatives counterparty risk." 

In guidance issued last May that took effect in September, the FSA revealed its assessment of the models banks have used to calculate the benefit of these deals in terms of reducing the amount of regulatory capital they need to hold:

"The underlying formula contains an implicit assumption that there is no systematic risk in tranches of diversified portfolios that attach at a level of credit enhancement above the capital requirement on the underlying portfolio. However, the performance of senior tranches of many securitisations since 2007 has shown this assumption to be flawed. In addition, where a firm’s [internal rating] model proves [later] to have under-estimated capital requirements on the underlying portfolio, the [model] leverages any undercapitalisation."

As Alphaville notes, this "ultimately means that banks come out with an answer that says they can hold even less regulatory capital" than they should. And the FSA states: "Therefore, the potential scale of firms’ use of the [models] for capital relief purposes is significant and the impact of any undercapitalisation due to the deficiencies in the [models] could become systemic." My emphasis.

That could mean another giant bailout is in the works, since the shadow banking sector was back to its pre-crisis size of $60trn by the end of 2010.

Yet again, the FSA has found itself outpaced by events, albeit perhaps the latest gap narrowed compared to the lag in response to the sub-prime crisis. And I guess it will be 2013 before we find out what flaws there were in bank capital models used during 2011.

But we should be wary of expecting too much of the regulators, given the culture they're up against... We're on our own: pay less, diversify more and be contrarian.