Fear, Greed and Regulation: The Basel II Effect
Are financial institutions ready for the Basel II implementation deadline early next year? Although the answer needs to be considered on a case-by-case basis, chances are that they have been getting ready at an accelerated pace for the last couple of years or so. The reason for this is that regulatory compliance might have become one of the key drivers of success and profit, alongside greed and fear.
A medium-sized European bank with a reasonably diversified loan portfolio would typically save more than a hundred million US dollars or euros in regulatory capital allocations by shifting from Basel-defined standardised methodologies to advanced calculation methodologies. This comes after the shift from Basel I to Basel II, when compliance rules would have already reduced capital allocation requirements in similar proportions at least. So, either way, complying with Basel II could considerably reduce capital requirements provided appropriate ‘housekeeping’ is being carried out throughout the loan books.
As an average CEO is typically assessed on the equity value and hence on the return on equity the firm provides, it is obvious that they are motivated to comply with Basel II. Most market participants wasted no time and embarked in cleaning up their balance sheets as part of a compliance program, leaving many financial institutions with a wall of money that they could choose to give back to the shareholders or put to work. This is perhaps one of the most unexpected consequences of the Basel programs, as it was widely understood that implementing stringent capital allocation rules would lead to tightening credit conditions, not the contrary. This leaves us with the next question – how is the housekeeping being carried out and where does the money go?
While it would be dangerous to generalise, the aftermath of the industry’s preparation for Basel II highlights that most banks, in the pre-Basel times, were not run blindly without any consideration for credit and market risk. After all, banking is managing credit risk before anything else and small businesses, sometimes family run, appear to be managed with more conservative risk policies that far exceed the Basel defined ratios. These financial institutions now somehow benefit from averaging down their capital requirement ratios with the likes of the global investment banks that have influenced the regulators. The latter are often governed with management techniques whereby return on equity directs policies. They typically try optimizing the use of capital through active trading and hedging and usually expose themselves to a wider range of risk factors and by a greater extent too. Therefore, when the regulators decided to impose the rule that all market and credit exposure would have to be risk-weighted, there was a simultaneous acknowledgement of the use of credit risk mitigation tools to reduce and control credit and market exposure. The subsequent boom in credit derivatives allowed financial institutions to clean up their balance sheets.
Yet not every book can be efficiently hedged with a credit default swap (CDS), notwithstanding the costs involved. In addition to direct hedges, billions of dollars worth of debt simply left the balance sheets and were transferred to special investment vehicles and liability driven structured products, such as collateralised loan obligations (CLOs) and synthetic collateralised debt obligations (CDOs). The massive liquidity of the CDS markets actually came from the depth of the upstream default protection market. The availability of new structured instruments coincided with a new appetite for high yield (i.e. risky) investments on the buy-side market, largely influenced by hedge funds, their rush for alpha and by the alternative investments strategies they have inspired throughout the asset management industry. As the practice of re-packaging securitised investments into structured instruments defined with risk-weighted tranches proved to be highly profitable, it became applicable and was generalised to almost any type of investment. Indeed, what was yesterday perceived as a high risk or highly illiquid investment, can now be sold to a conservative pension fund as a high yield tranche of some structured security, underwritten and marketed by some of the most respectable names in investment banking.
Not only do capital hungry risky investments tend to leave the balance sheet, but securitised investments backed by mortgage or by government securities that require much less capital to be allocated also followed suit. As a result, liability driven investments were doubled with a fast rise of mortgage-backed, asset-backed and security-based structuring, which deeply affected the underlying markets as we have all witnessed over the past few months.
Another unexpected consequence of tightening credit terms and conditions with more stringent rules is that it seems to actually make more capital available for lending. Improving an equity ratio also reduces the apparent efficiency with which shareholders’ funds are utilised. In other words, whoever doesn’t want to pay back a lump sum to shareholders would be naturally led into lending more money to more customers. And this is how bubbles inflate: when investing no longer is a question of finding capital to fund assets but when flows of capital need to find some assets to be invested in. A few banks, obviously a small minority, did distribute exceptional lump sums to shareholders. Most others developed aggressive strategies to tap the booming markets, such as real estate, funds, emerging markets and other investments with risky profiles.
This is not to say that Basel II is responsible for the imbalances that the financial industry is currently exposed to, but it underlines the fact that when one changes the rules of a complex ecosystem, then one might expect direct and indirect consequences, some of which are totally impossible to predict as they actually arise from a combination of factors. The unique combination in this case is that a wall of money was made available for lending at the same time that the industry’s risk appetite had evolved to high yield products. To add to this, the arrival of modern structuring techniques which help to package just about anything into tranched securities; the demand by institutional investors across markets for shares of funds that themselves package alternative investments; the population of baby boomers who have come to the age of retirement hungrier and more sophisticated investors than their parents were, that money flows out of Asia, the Middle East, etc. are all relevant factors that have worked together to create a situation that could not have been predicted at the outset.
So are banks ready for Basel II yet? The answer all depends on how you define readiness. If it is about complying with regulatory capital allocation rules, chances are that most have been in full compliance or have even been exceeding requirements for some time already. If it is about punching out reports with all counterparty data disclosed in a risk-focused fashion and making sense of the diversity of the various books that an average diversified financial institution currently manages, then one can testify that when considering the amount of work that has been carried out in data management and system integration across Europe for the past five years, that in most cases there should be no major problem with regards to this aspect either.
However, if the spirit of Basel II was to create a safer and more profitable marketplace by harmonizing risk policies with capital allocations and leading all participants to adopt best practice operations, the outcome could actually be the opposite of what was initially the desired effect. By establishing norms and codifying practices, every single set of rules invariably shows ways that they can be overridden. This case is no exception. The second point is that Basel II regulators and consultative papers have been greatly influenced by the comments, practices and codes of conduct of the Tier 1 banks. The rationale must have been that big is beautiful, so that if the entire industry were to take a Tier 1 bank approach to risk management and operational control, then this would benefit all. However, the recent credit crunch has tended to prove that this might not always be the case.