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# Risk Weighted Capital Adequacy: The Elephant In The Davos Jacuzzi

Stock-Markets / Market Regulation Feb 02, 2010 - 10:13 AM GMT

One of the “pillars” of financial regulation is the idea of risk weighting.

The way that works is that “assets” which in the case of banks are typically either loans to other people or securities held by the bank like US Treasuries or Sub-prime RMBS (the Brits call those bonds), are assigned a risk weighting by the regulator.

Based on that the “Risk Weighted Capital Adequacy Ratio” (CAR) is worked out, the regulator specifies a minimum number for this, typically 8% to 10%.

So if all the banks do their sums properly and keep their CAR higher than the minimum specified by the regulator, the financial system will be “Risk Free”, because if everything goes wrong there will be a “cushion”. Or that’s the theory.

There is only one thing wrong with that theory which is that it doesn’t work….evidently. In fact the “cushion” turned out to be more like one of those joke cushions that make a rude noise when you sit on them.

Here’s why:

These are the basic formulas (you can make it more complicated than this but I’m talking Big Picture here):

(1): Capital Adequacy Ratio (CAR)  ≥ 10% (say) = CAPITAL ÷ RISK

(2): CAPITAL = (Value of) ASSETS – LIABILITIES (i.e. for a bank, debts).

(3): RISK = (Value of) ASSETS x RISK WEIGHTING

So:

(A): According to equation (3), if your assets are all AAA Subprime RMBS then the risk weighting on those things (in USA) is 20% so if you own \$100 of them your RISK is \$20.

(B): That means your CAPITAL needs to be at least \$2.0 if the threshold set by the regulator is 10% (Equation (1)).

(C): That means your LIABILITIES can be as much as \$98 (Equation (2)).

(D): So (QED) your Liabilities (\$98) can be 49 times your capital (\$2)

That’s more or less how Lehman managed to get away with a gearing ratio of 30:1 although the “experts” will tell you it’s a lot more complicated than that and that ordinary mortals can’t possibly comprehend the “complexities”. It’s not complicated, big picture, they borrowed a lot of money and they couldn’t pay it back mainly because they pissed it all away paying bonuses.

One of the things that happened was that after buying \$100 worth of toxic debt by borrowing \$98 they found out that their “assets” suddenly became worth a lot less than they had paid for them, like about half so they suddenly had \$50 of assets (plus \$2) of capital to pay back \$98 of debt.

Some “cushion”! That’s how the estimated \$400 billion of losses on the sub-prime mortgages got translated into about \$800 billion or so of losses to the financial system (and counting; rough numbers – for illustration). The “solution” to that originally proposed under TARP and now being put into action by the Fed which has bought about \$1 trillion of toxic assets (at an undisclosed price – National Security apparently), was for the government and it’s agents to buy the toxic assets at above what the prevailing market price was, so as to get the banks off the hook so they could go out and do it all over again, because apparently that’s “good for the economy”.

Of course if you borrow short-term from the Fed’s discount window at 0% and then buy AAA 10 Year US Treasuries paying 3.5% which have a Risk Weighting of 0%, or better still “agency AAA Sub-Prime RMBS” which are explicitly guaranteed by the government (and pay more), then theoretically, your liabilities divided by your capital can be infinite so you don’t need any capital to do that at all.

Which goes a long way to explaining why the parts of the US Banking system that have got the right “connections” are so profitable these days (and the bonuses are so huge), even though they are technically insolvent (zero or less capital).

It also explains why banks are so reluctant to lend money to people, unless they can get “loan shark rates”, because the risk weighting on things like that is much higher (50% to 100%), so that means you have to have capital to lend to people, whereas if you stick with the US Government and (in the old days) AAA rated Sub-Prime RMBS, well you didn’t (don’t) need to have hardly any capital, and you could (can) make just as much money.

Which is why it doesn’t matter how much fiat money the Fed pumps into the banking system, it won’t cause inflation in the general economy (although it might cause localised inflation in the places bankers live), because it’s not going to get there.

People say bankers are greedy. That’s disgracefully unfair, ask yourself if you could get yourself in a position where you could borrow at 0% and lend at 3.5%, and that was absolutely risk free (and legal), well you would do that too, as much as you could.

So if that’s so “Low Risk”, i.e. SAFE, why was there a credit crunch?

I noticed a clip from Hank Paulson’s book, where he said that he would have bailed out Lehman (which some say would have forestalled the unpleasantness of the past eighteen months), but then he found out that the valuations of the assets was to use layman’s language, completely wrong. That was obviously a bit of a surprise to him because a few months earlier he had declared to the world that “The US Banking System is a Safe and Sound One”.

There lies the rub, you might have noticed that I wrote “value of” assets; not many people write that (in fact as far as I know no-one does) because when you say “assets” it is assumed that you are talking about the “value” of the assets.

Same thing for liabilities, although the value of liabilities are quite easy to work out, so if you borrow \$100 from a pay-day lender (for example) and agree to pay him \$10 a month, you know after one month your liability will be \$110.

The value of your (own) assets is of course rather more complicated to work out, for example if you don’t pay up the \$110 after a month the pay-day lender might send someone around to break your legs.

Then you get into the complications of valuation, basically you need to work out if your legs are worth more than \$110 to you, and the pay-day lender needs to work out if it’s worth \$110 (or more) to him to break your legs (typically it is, that’s  because he uses you as an “example” to persuade other people like you that he is serious and so they are inclined to pay up on their liabilities. So he might temporarily forego the loan repayment for the long term return on investment on that transaction and put your \$110 down as a business expense (and anyway quite often he will keep the option to break your arms at a later date)).

So when you talk “valuation” particularly about assets, you also need to ask the question about to whom; and most important; WHEN?

For example a typical clip you see in movies when the leg-breakers come around to catch the hero, he tells them, “no…no don’t break my legs, see here I have a lottery ticket which will pay out tomorrow, just give me one day”.

So that’s the Theory all explained, how about the “practice”?

My business partner is Australian and I would like to take this opportunity to remark that Australians are not half as dumb as they pretend to be, particularly those of the female persuasion.

If you want proof of that, have a look at:

http://australiansecuritisation.com.au/docs/rmbs_letter_to_apra.pdf

That document was written in 2002 and it’s a classic; it’s about someone trying to persuade the Australian financial regulators to drop the risk weighting on RMBS from 100% to 50% (at that time USA was 20%). Clearly the okker Aussies were very suspicious about these new-fangled-things, (they probably suspected the Poms had something to do with them); although the promoter of the idea was laying it on the line, pointing out that if the Australians didn’t keep up with events, there would be less liquidity and Australia could be left in the dust with a bunch of flies in their soup. I liked this line particularly:

The process of securitising the underlying assets includes a rigorous due
diligence on those assets by a third party global rating agency, which
imposes stringent parameters on the vehicle issuing the RMBS.

Yup that’s what financial regulation is about, “stringent” and “strict”, and that’s what keeps Americans (and their 401K’s) safe at night. Although that dumb attitude of the Australians may help to explain how come they came through the credit crunch relatively unscathed.

Reforming Financial Regulation

Leaving aside what Niall Ferguson called “Banker Whacking”, the talk amongst the financial glitterati in and around the recent Davos get-together was all about “too big to fail” and capital adequacy. Both of those ideas are about how “the system” can be protected in case there is another financial meltdown.

By way of translation for anyone who isn’t familiar with the terminology, what “too big to fail” means in reality is “too big to bail out”.

That’s because it’s pretty clear that when push comes to shove all big banks will be bailed out so the main risk is that they become so big, and create such a big mess, that no one can bail them out; in which case the world will stop turning around.

As I have already explained, capital adequacy is something along the same vein; it’s not a new idea, which is that the capital should be enough to cover all eventualities, so that it’s not necessary to resort to “too big to bail out”. That’s like a first line of defence, with the bail-outs as the second line of defence.

What’s clear is that the focus of all that is on fire-fighting. That was very well put by Secretary Geither when he first presented the Financial Stability Plan that was going to save the world last March; in answer to a question from the floor he said in defence of his plan “you can’t fight a fire with a committee”. That of course is absolutely true although there no sign that the glitterati have woken up to the whacky idea that the very best way to fight a fire, is not to start one in the first place.

But that’s not what financial regulation is about, it’s about making sure you have “cushion”.

Like designing a car from the air-bags up; first you work out what will happen if you crash it into a wall at 100 miles an hour, then you make sure the safety system will protect the passengers (including automatic fire-extinguishers), then you design the transmission, the engine, and the cup holders etc, and you are ready for the road!

The overwhelming consensus is that the recent financial crisis was a Black Swan event that no one could have foreseen or anticipated, and so it was completely unavoidable. Therefore since what happened before, could happen again, without any warning, and could again take all the experts entirely by surprise, obviously what needs to happen is to BUILD BIGGER AIR BAGS.

Modern financial regulation is a very precise science, and it’s all about RISK, unfortunately it doesn’t appear to have occurred to a many people (if any) that just like not starting fires, there are other ways to avoid getting hurt by driving a car into a wall at 100 miles an hour.
For example navigation, that way you can avoid the wall, driving your car at 30 miles an hour (in built up areas) is another ploy, as is buying a better pair of spectacles so that you can “look into the future” (i.e. see where you are going), along with having the imagination to work out that if you keep going on the trajectory you are going, you might collide with a wall.

Basil and the Stress Tests

I think it’s unfortunate that the Bank of International Settlements (BIS) decided to name their banking regulations which are considered to be the most up-to date, modern, and scientific in the world, after Basil Fawlty in Fawlty Towers. Although I suppose at least that proves that banking regulators do actually have a sense of humour after all.

However they disguise that well. For example if ever you are in one of those situations where you flew half way around the world and you are sitting in your hotel room at 4.00 in the morning (local time), and you are completely wired and wide awake, but you know that you have to make a presentation at 9.00 the next morning and if you don’t get some sleep you will probably fall asleep half-way through (your own) presentation; I can strongly recommend that you get a copy of the latest (2009) version of, “Principles for sound stress testing practices and supervision”.

http://www.bis.org/publ/bcbs147.pdf?noframes=1

It’s a superb resource; only twenty-four pages but single spaced, and it manages to say absolutely nothing about anything of any relevance to the real world in the most obtuse and incomprehensible way.  I challenge anyone to read more than five pages at one sitting without falling into a deep and dreamy sleep.

In summary what it is about is as follows:

A: “Providing forward-looking assessments of risk”; (looking where you are going as a way of avoiding driving into a wall at 100 miles an hour).

B: “Overcoming limitations of models and historical data”; (looking out of the windshield rather than trying to drive by looking in your rear view mirror).

C: “Supporting internal and external communication”; (flying off on junkets and going to lots of golf days).

D: “Feeding into capital and liquidity planning procedures”; (absolutely no idea what that means).

E: “Informing the setting of a banks’ risk tolerance”; (correct me if I’m wrong but that’s not actually English is it)?

F: “Facilitating the development of risk mitigation or contingency plans across a range of stressed conditions”; (keep up the campaign contributions and the budget for lobbying and keep the home numbers of the bail-out people on your speed-dial).

There was one thing that was conspicuously absent from those twenty four pages however, was any discussion or guidance about how to report on the value of assets.

That was a bit of a let down, particularly since what happened recently in the financial crisis was, as is explained in the example above, that the “value” of assets turned out to be a lot less than the value that had previously been assigned to them when the banks worked out their CAR, for example in July 2008 when Hank Paulson boasted about how fantastic and STRONG the US banking system was.

The Elephant in the Jacuzzi at Davos

Look on the Internet, listen to the speeches and the positions, it’s as if all that needs to happen is that improvements need to be made in the measurement of Tier 1 capital (that’s how much you got spare to dish out and still remain in business), and Tier 2 capital (that’s how much they can squeeze out of the sponge if you go bankrupt).

In the previous example, a bank that had 100% of it’s assets in toxic debt might have had a total capital (Tier 1 and Tier 2), of \$2 against a net liability of \$46.  So I’m a bit confused here, what difference would it have made if the capital was say \$4?

The mistake, which the whole financial system is studiously trying to ignore, like an elephant in a Jacuzzi, is that the valuations were wrong, hopelessly wrong.

And as anyone who has ever been beaten up by a loan shark knows, it doesn’t matter what you might have been able to sell your collection of miniature cuckoo clocks for last week (or what you paid for them last year), and it doesn’t matter what you might be able to sell them for next week, or next year; what matters is how much you can sell them for on the day that one of them is holding you down and the other one is swinging the sledge hammer.

But no one asked that question, literally no one. That was never on the agenda, no one asked the question “what is a realistic estimate for how much I can sell my miniature cuckoo clocks for, at some unspecified time in the future, in a hurry”.

I checked, I looked up Basel II which is the Authorized Version of The Bible for Bankers, it is 251 pages (single spaced), and although it clearly recognises that the idea of “value”, for example it mentions the word 150 times, there is no explanation or guidance on how to do a valuation.

Also it says absolutely nothing about the fact of life that anyone who has been held down by a loan shark has hard-wired into his consciousness, that when you do a valuation you need to know (1) Who to? (2) When?

Interestingly in July 2003 the International Valuation Standards Committee wrote to BIS and pointed out that the valuations that people were employing in order to calculate CAR were, quote; “hopelessly flawed and bound to be misleading”.

Well here is some news, that’s what the credit crunch was about, the valuations of about \$20 trillion of securities created in America (with Pride) between 1998 and 2008, were  exactly that….“hopelessly flawed and bound to be misleading”.

The reason that those toxic assets were allowed to have a 20% risk weighting, is because they were supposed to be liquid; so that when you heard the bang of the loan shark breaking down your door you could nip out the back and sell them to that nice little Chinese man who runs the take-away round the corner, for CASH.

Well, they weren’t. Why is another story, but it’s got nothing to do with greed, and it’s got nothing to do with the thousands of pages stultifying  and incomprehensible ass-covering that has been churned out by the people who were tasked with protecting the financial system and the 401K’s of ordinary Americans (and others), and didn’t.

And sorry, it wasn’t a Black Swan and it wasn’t greed, it was simply incompetence on a huge scale.

The Future of Financial Regulation

What has been produced so far by the deliberations of Basil & Co, since it contains no guidance on valuation, is about as useless as the Neasden County Council guidelines on Health and Safety.

Thousands and thousands of unreadable pages of “guidance” and encouragement to do “Risk Management”, like when you rent a rowing boat to go out on a two ft deep lake with a ten year child who knows perfectly well how to swim and is three ft tall, (and who knows you might have wanted to drown the little brat anyway?)  And you are obliged to wear a life-jacket as part of the Health & Safety Regulations.

How about focusing on the real problem?

How about suggesting (politely) to banks; that they might like to value their assets when they are working out their capital adequacy, by using International Valuation Standards?

Or in other words to look where they are going (i.e. in the future), whenever they decide to drive at 100 miles an hour, just in case that newly beefed-up air-bag doesn’t work, or in case they hit some innocent bystander.

By Andrew Butter

Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe; currently writing a book about BubbleOmics. Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.