April 11, 2011
Hon. Ben Bernanke, Chairman
Federal Reserve Board
20th Street and Constitution Avenue NW
Washington, DC 20551
Hon. Sheila Bair, Chairman
Federal Deposit Insurance Corporation
550 17th Street, NW
Washington, DC 20429
Mr. John Walsh, Acting Comptroller
Office of the Comptroller of the Currency
Administrator of National Banks
Washington, DC 20219
Re: RINs 1557–AC99, 7100–AD61, and 3064–AD70: “Risk-Based Capital Guidelines: Market Risk”
Dear Chairs Bernanke and Bair and Acting Comptroller Walsh,
Americans for Financial Reform (“AFR”) appreciates this opportunity to comment on the Notice of Proposed Rulemaking regarding Risk Based Capital Guidelines: Market Risk (“Market Risk NPR”). AFR is a coalition of over 250 national, state, local groups who have come together to advocate for reform of the financial industry. Members of the AFR include consumer, civil rights, investor, retiree, community, labor, religious and business groups along with prominent economists and other experts.
This NPR implements provisions of the Basel III agreement relevant to the use of internal risk modeling to set risk-based capital levels for financial institutions. As a general matter, AFR is highly skeptical of the use of internal bank Value at Risk (VAR) models for setting capital requirements. From the time the Basel Committee first proposed the use of such internal models, serious questions were raised about the wisdom of relying on regulated entities to calculate their own required capital ratios.1 Observers also pointed out that such models contained an inherent, powerful structural tendency to reinforce economic cycles, with excessive leverage encouraged at the peak of an economic cycle as risk appears low, and abrupt and harmful deleveraging during economic downturns.2
The financial crisis of 2008 demonstrated in the strongest possible way the validity of these concerns. Predictions about the incentives for regulatory arbitrage and the pro cyclical nature of VAR-based capital standards were shown to be prescient.3 Banks took advantage of low regulatory capital charges for instruments that turned out to be extremely risky – most notably, upper tranches of subprime mortgage-backed securities with investment grade ratings. They also arbitraged between the trading and banking book to take advantage of low mark-to-market capital charges. Regulatory capital arbitrage drove similar incentives across banks, increasing correlation in the financial system and “herding” into particular asset classes. Finally, just as predicted by critics of VAR modeling, leverage ratios grew sharply during the upswing of the economic cycle, and the sudden rush to deleverage as asset values dropped led to disastrous financial contagion and a self-reinforcing downward plunge in market valuations.
Despite these deep structural problems with regulatory reliance on VAR-based risk modeling by the banks they regulate, the Basel Committee has chosen to continue the use of such models in setting risk-based capital charges. But in response to the clear failure of this paradigm over the past decade, regulators are implementing a substantial set of modifications to the risk-based capital framework. These modifications are proposed in this rule. They include transfer of all securitizations from the trading to the banking book, the incorporation of a “stress test” into the VAR model that is meant to mitigate tendencies toward pro cyclicality and tail risk, an incremental capital charge for default risk, and mandatory disclosures of risk management modeling assumptions to allow for greater market discipline.
If fully and properly implemented, these changes should result in a substantial increase in risk-based capital required under the VAR regime.4 New capital charges based on modeling a stressed time period are particularly important, as they hold the potential to reduce the pro cyclicality of VAR-based capital charges. Some of the new risk weighting procedures, such as a substantially higher capital charge for uncleared derivatives, should also create incentives for better risk management practices across the financial system.
The significant but basically incremental steps directed in Basel III and implemented in this NPR are the least that should be done in response to the striking failure of the previous regime. It is important that regulators implement these steps fully and rapidly. Their resolve to do so should be increased by the awareness that the true social costs of higher bank equity are likely very low, if they exist at all.5 The costs of increased bank equity are mainly due to subsidies for bank debt through the tax system and through implicit “too big to fail” government guarantees, as well as principal-agent issues between bank management, stockholders, creditors, and taxpayers.6 These implicit subsidies and guarantees should not be allowed to drive government policy.
In addition, regulators should remain aware that capital level held by the key banking entities that failed during the crisis of 2008 was both higher than the regulatory capital requirements under Basel II and demonstrably lower than the level needed to prevent institutional failure and financial contagion.7 The fact that the capital requirements under the previous regulatory regime were clearly too low to accomplish regulatory goals justifies a significant increase now.
Although they are a step in the right direction, the rules laid out here may still turn out to be inadequate over time. These rules are specifically directed at some of the key instruments that caused problems in the last crisis, such as securitizations and re-securitizations. As the financial sector evolves, it seems almost certain that new arbitrage techniques will emerge that permit arbitrage of these rules just as the Basel II rules were arbitraged.8 The emergence of new instruments may also weaken the stressed VAR capital requirement set out in this rule, as this requirement is “calibrated to reflect historical data from a continuous 12-month period that reflects a period of significant financial stress appropriate to the bank’s current portfolio.”9 As current portfolios evolve and new instruments and investment strategies are created, less historical data will be available that represents an appropriately stressed period.
In light of these concerns, AFR has several broad recommendations for strengthening the rule:
Disclosures should be strengthened, particularly in the area of the qualitative disclosures required for valuation procedures and stressed VAR. Purely qualitative disclosures may be of limited utility in this area. Correlation assumptions and specific quantitative valuation assumptions may be required for market observers to tell if a bank has truly applied stringent standards. The market may be able to act more quickly than regulators in disciplining banks for any attempt to weaken these assumptions.
Regulators are given very significant discretion in determining the application of these rules. In light of this, it would be useful to announce more specific and standardized quantitative benchmarks for various areas of the rule, e.g. standard increases in correlation for periods of market stress. This would help examiners check bank assumptions more easily and would help guide risk management practices in regulated banks. Such benchmarks may be particularly important in the calculation of stressed VAR, which is a key mechanism to address the pro-cyclicality of the current system but is an area where only very general guidance is currently given.
Regulators should consider further limiting the trading book treatment of financial assets, even beyond the new treatment of securitizations given here. The downward spiral in prices during the financial crisis showed the risks involved in mark-to-market treatment of risks held on the trading book. Such valuations are inherently highly volatile, and most volatile during times of crisis. Financial institutions may develop instruments that replicate some of the risky and opaque character of securitization tranches but are not captured by the definition of securitization here, and may once again use the trading book to get more generous capital treatment for such assets.
Even if these recommendations are followed, some of the basic structural aspects of risk-based capital regulation – such as the dependence on historical data and the division of assets into different risk “buckets” that can vary greatly in treatment – render regulatory arbitrage and other weaknesses a continuing possibility. The Basel III framework partially recognizes this through providing supplemental liquidity, leverage, and capital standards in addition to the risk based standards. But regulators must remain vigilant to ensure that the same problems that appeared in the past do not reemerge in this regime.
Thank you again for this opportunity to comment on this NPR. If you have the further questions, please contact David Arkush, Director of Public Citizen’s Congress Watch at (202) 454-5130 or Heather McGhee, Director of the Washington Office of Demos at (202) 559-1543 ext. 105, Co-chairs of the AFR Systemic Risk and Resolution Authority Taskforce.
Sincerely,
Americans for Financial Reform