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.

Anyone For 8% Market Share?

Barclays' withdrawal from the asset-based small business lending market is a real shot in the arm for peer-to-peer finance.

The head of the Barclays Business unit is quoted as saying, “It’s the leasing and hire purchase side [where] we found our proposition was not that compelling, comprehensive and competitive. Our market share was small, about 8pc.”

Those are my gob-smacked italics.

According to the same article, the Finance and Leasing Association "said asset finance represents the majority of debt-financed business, and that its members provided £1.7bn of funding to support business investment in December, 5pc higher than the same month in 2009."

Barclays says it can target this £21bn market segment with unsecured loans. But of course it's talking through its hat. The Basel III head-wind blows strongest in the unsecured lending space. So even if Barclays can magic the £1.7bn asset-based portfolio into unsecured loans, it doesn't seem a great alternative use of capital.

But it's an interesting strategy if you're lending some of your own cash on a peer-to-peer platform, instead of leaving it in a savings account.

Barclays stands to lose out on both fronts.

Image from Gogherty.com.

Hey Eric: Lend Your Euros Directly To Other People

Like previous financial crises, this one won't end until individual and collective confidence in banks and the financial system is restored. And while it's all very well for the Eurozone's political masters to be demonstrating their 'political will' to hold the Eurozone together at individual taxpayers' expense, their latest attempt at restoring confidence has not exactly impressed Spain's debtors...

But such bail-out headlines merely the typically dominant institutional narrative. The real question is whether the Euro and EU institutions actually have the confidence of EU citizens - especially taxpayers. A recent poll suggests they do not: only 42% of Europeans trust the European Union - reflecting a general disenchantment with EU institutions over the past few decades. Meanwhile, in sharp contrast, bottom-up facilitators that enable citizens to participate in shaping and personalising their own services have done very well.

This is reflected in the behaviour of EU citizens on the economic front. The implications of the one-size-fits-all Eurozone monetary policy seem to be regarded as just as unfair by German taxpayers and the French savers supporting Eric Cantona's suggestion for mass bank-withdrawals on 7 December as by those hitting the streets of Greece and Ireland. The Guardian quotes Valérie Ohannesian, of the French Banking Federation, as saying Cantona's appeal is "stupid in every sense". Yet, crucially, she did not explain why people should feel more confident about leaving their money on deposit, or why it is fair that banks receive taxpayer bail-outs while taxes increase and spending is cut. In the absence of any other narrative, each bail-out undermines our confidence even further, to the point where we hit the streets and seriously consider suggestions like Eric Cantona's.

But it doesn't have to be this way. There is a bottom-up narrative emerging, and our politicians need to focus on it.

Eric Cantona's confident call for mass withdrawals hints at the fact that people are prepared to put their money where their mouth is. But it would be futile for those with surplus cash languishing in low interest savings accounts to withdraw it all and hide it under their beds. Instead, they should join those who already put their money to work helping others, by lending it directly on peer-to-peer lending platforms to creditworthy people and businesses at a decent rate that also represents a decent return.

Swiss Tailwind For Personal & Small Business Social Finance

Banks will find it more costly and less profitable to offer short term unsecured personal and small business finance under Basel III rules, according to a recent McKinsey report.

To comply with the new rules, Banks face a long review of their businesses and products to reduce risk, use capital more efficiently and minimise the need for market funding by the end of 2012.

Which is more great news for participants in the 'capital light' social finance business models, like Zopa and Funding Circle in the UK.

As I mentioned in the context of the proposals to regulate vertical shadow banking functions, people using these 'horizontal intermediaries' benefit from:

1. Loan amounts being split into small one-to-one loans at inception, rather than having to wait for the slicing, re-packaging and grading involved in asset-backed securitisation;
2. A direct, one-to-one legal relationship between borrower and lender for the life of the loan, enabling better control over debt adjustment and collection, where that becomes necesary;
3. Lenders retaining day-to-day control of the management of their money and credit risk, minimising the capital required by the intemediary;
4. The intermediary not needing to slice and re-package debt to alter loan maturities, since lenders can manage this by assigning loans of unwanted duration to other lenders;
5. The intermediary having no balance sheet risk, and therefore no temptation to engage in expensive and complex regulatory, tax or other arbitrage;
6. Transparency in the original underwriting decision and loan performance against grade - making lenders' due diligence easy, and removing the moral hazard of the kind we see in vertical intermediation models, where the endless slicing and re-packaging makes due diligence hard.

For these reasons, one might expect banks to allow their depositors to lend directly to their personal loan and small business customers. But it seems unlikely the banks could feed themselves on the scale of fees their nimble competitors can afford to charge. And they would soon face calls to allow the peer-to-peer approach for mortgages and larger corporate loans - by which time other nimble providers may well beat them to those segments too...

Image from Gogherty.com.