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Memo to Regulators: Here's How You Should Regulate Capital Requirements

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Size, risk, complexity, and how capital is used should factor into any formula. Instead of a flat percentage, banks should allocate equity the way a hedge fund would.

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Bank regulatory capital has been in the news a lot recently. In Europe, there's been a lot of discussion about the capitalization of Spanish and Greek banks. In the US, the concept of Too Big To Fail (TBTF) has been parried between regulators and banks with the former demanding more regulation and the latter fighting any new rules. Against this background JPMorgan's (JPM) surprise loss pushed the debate to a fever pitch: What is the appropriate regulatory framework and what should capital requirements be?

Now is a good time to step back and think about what capital is supposed to do. And, with that as a guideline, think about the rules that make sense.

What Is Regulatory Capital?
Simply, it is the amount of capital that the banks are required to hold against their assets. Generically, though, the concept has evolved along with various Basel Accords. Regulatory capital for various debt instruments is 8% of the bank's risk-weighted assets. Risk weights vary dramatically: from 0% to high-rated sovereigns to 50% for investment grade corporate bonds rated "A" to over 150% for high-yield corporate bonds rated below "BB-".

Under Basel II, there are regulatory capital charges for credit default swaps (or CDSs) with respect to counterparty exposures (under a complicated formula). Further, there are rules under which CDSs can partially offset for the required capital cash assets. Risk weights are multiplied by the 8% capital requirement for debt instruments. For example, "AA"-rated sovereigns that uses no regulatory capital (infinite regulatory capital leverage) would carry a zero charge. An "A"-corporate would have a 4% charge (25x leverage) and a high yield "B" bond is 12% charge (8.3x leverage). From a regulatory capital perspective, therefore, the banks are incentivized to put on large positions of highly-rated debt.

What Is Regulatory Capital Supposed to Do?
Surprisingly enough, there are actually lots of different answers. Many mistakenly believe that it should cover a bank's potential losses in a portfolio with some cushion. That is wrong: No bank ever gets the luxury of seeing if, over the long run, the capital is enough to cover actual losses.

Bank runs start when people become concerned that if a bank had to liquidate its portfolio, there wouldn't be enough money to cover all depositors. So no matter what style of accounting a bank uses, at some basic level, investors react to the perceived value of the assets, not eventual value. That is a key distinction.

Depositors reacting that way are the biggest threat, because if they pull deposits, then banks have to sell assets -- even those they hoped to hold until maturity. If the bank isn't relying on short term funding, the run is less likely, and they have more ability to weather the storm.

So, regulatory capital, or capital adequacy, or just plain capital, needs to address the worst possible eventual loss or potential mark-to-market loss.

Since mark-to-market loss risk is almost always worse than the eventual loss, that needs to be a key focus. The way a bank funds itself is also important. The less it has in "demand" deposits, or short term debt, the more control it has over the asset side of the balance sheet (no forced selling), so the liability side has to play a role in capital determination.

Size Matters
Let's start at a very basic level. Owning $1 million, $10 million, or $100 million of an individual bond is very different in the real world. In considering the probability of default along with what would eventually be recoverd (recovery analysis) regulators demand a fixed percentage of capital for each position. If default expectation was 10% with a 50% recovery, then the bank would hold 5% capital against the position. In theory.

In the real world, no matter what the risk of eventual loss is, the risk in a trading environment is much different as the position grows. To sell a $1 million position, you can call any number of dealers and get out at a price. If the first place you call is out grabbing coffee, you don't care and just dial another dealer.

If you have $10 million, you have to be a bit more selective. You need to work with someone a little bigger, possibly someone who specializes in that bond. Alternatively, you can "spray" the street and sell small size batches to a bunch of dealers. In any case, $10 is harder to dispose of than $1 million.

Selling $100 million in bonds takes exponentially more effort. Instant liquidity is impossible. You are going to have to work with someone very specialized or various parties over an extended period of time. Your very action of selling will move the market against you while your're in the process of unloading the bonds.

So in a "progressive" capital system, if 5% is the "right" portion of capital to hold against a small position, then at $10 million perhaps you're looking at 6% to offset the risk of a larger position. By the time you get to $100 million it is 10%. This isn't saying that you cannot be large and outsized in a position, but it is saying that you better evaluate whether that extra risk is worth the extra capital charged.

Notice that nowhere have I mentioned ratings yet, and I won't -- at least not directly. Figuring out the "expected" loss may require some ratings-based rule, or internal models; I'm willing to concede that. But liquidity has nothing to do with ratings. The liquidity will be applied diligently across all assets.

The financial crises in the US and Europe have one thing in common: They were caused by huge positions in what was formerly thought of to be a low risk asset. In unloading that low risk asset things turned ugly. In the US it was primarily AAA tranches of various forms of mortgage backed securities and asset backed securities. In Europe it was primarily sovereign debt.

For all the fear of high yield bonds, other than Drexel, not once have they been at the heart of a financial institutions meltdown -- and even the Drexel case was less about the risk of the bonds themselves.

So by ratcheting up capital requirements tied to position sizes, regulators can stop banks from building positions that are too large. The liquidity premium increase is fair because you can almost guarantee that by a time a bank is selling one of these formerly "safe" assets, it is selling into a falling market.

Portfolios Matter
Now we have to apply the same concept across portfolios. If you have 50 positions of $10 million each, you have more risk than having 20 positions of $10 million each. So again, the concept of additional, or incremental regulatory capital charges for larger total portfolios should be applied. Some of this will be picked up by asset capital charge, but it is important to look at the overall portfolio. Bigger portfolios add more risk in a scenario where you have to unwind unexpectedly.

Now we circle back to "expected loss." To use a concept like "expected" loss, you need a large enough sample of assets to assume that it will perform as "expected." For fixed income this concept is particularly important because in the end, there are only two states -- defaulted and trading at recovery value or paid in full. Over a well diversified portfolio, I'm willing to accept this concept -- so long as the additional capital charges for size are in place, but we need to look at the problems in applying it.

A portfolio with 10 positions of $1 million each is different than a portfolio with one position at $1 million and one position of $9 million. The "expected" loss might be the same, but the deviation of outcomes is much different.

To illustrate a point, let's assume a 50% recovery (which in the real world is also a variable that moves around and is different for each company). In the first portfolio you could have anywhere from 0 to 10 defaults, so the range of outcomes is no loss to $5 million loss; the different scenarios will center around the estimated default probability and the correlation. A little bit too statistical for my tastes, but I think it's workable and can be done in a way that creates a sound banking system.

The second portfolio also has the same range of outcomes, but in reality there are only four scenarios. Both default, both survive, or only one defaults. In the both default or both survive scenario, it looks a lot like the 10 name portfolio. But if only one name defaults, you become very sensitive to which name defaults. If it is the large name, then the bank will have a loss that would require nine defaults in the well diversified portfolio.

So expected loss has to be adjusted for large positions as well. The more "smooth" a portfolio is in terms of size, the more sense it makes to apply an expected loss rate uniformly. But large individual positions in that will cause disproportionate problems in the downside if there was a bad decision made.

So expected losses can be applied uniformly across a well diversified portfolio where each position is similar. For less diverse portfolios, or individual positions that are relatively large, the expected loss has to be adjusted upwards to provide more protection for bad decisions. This is in addition to the "liquidity" surcharge.

Will any of this ensure TBTF doesn't happen? No, but it will more properly adjust capital to take into account unwind risk and bad credit selection.

How You Use It Matters
Now we enter into the "complexity" charge arena.

Hedges are once again front and center. The only "perfect" hedge is selling an asset. Not owing an asset is the best form of risk control. There is a cost to not owning the asset -- lack of income, possible relationship damage -- but that is the only way to ensure there are no losses.

What about if the bank buys CDSs against the position? How much risk relief should it get? Not as much as they currently get because now the bank has two positions a loan/bond and a CDS. The bank has money tied up in the loan. That is not a problem if they sold it, but having a hedge means they continue to rely on borrowing.

They need to monitor the loan, book the profit and loss on it, etc. So even if they were "fully" hedged, they still need to do almost all of the work they would do if they owned the loan outright.

Also, in the case of loans they maintain a direct relationship with the lender, which may influence their decisions -- a key consideration in times of stress.

With the CDS, they now need someone to monitor that trade. They actually created a personnel cost by having this trade. Further, they have created counterparty exposure where they had none previously. The big problem here is that if the underlying name is tight and the counterparty is good quality, minimal (perhaps no capital) is attributed to the short position. That is wrong because, by the time that protection has value, the underlying company credit is deteriorating and the counterparty is also likely in worse shape.

Now, let's say that a bank is known to have a huge position of long assets and short CDSs. Will the hedge perform as meant to in an unwind situation? No it won't, not at all. So again, regulations have to focus more on unwind, then final outcome, because that is what drives banks.

If the asset attracts X capital and the hedge attracts Y capital, I'm not sure that the two positions shouldn't attract X+Y capital. Maybe there should be some discount for the "offsetting nature," but certainly not full capital relief. This "hedge" is also a trade. The risk profile looks very different than having sold the loan, and the capital should reflect that.

Complex Books and Trades
Complex books aren't the same as complex trades, but both should require escalating capital.

A bank with 10 derivative trades is simpler to monitor than one with 100 or 1,000. The concept is similar to notional escalation. The potential for error, and the time and effort required to unwind, go up. So the base case capital should increase as the number of trades goes up. This will be great for cash bond and loan trading. Banks can own a bond, not own a bond, or be short it.

Derivatives are a complex mess of buys and sells. Banks can continue to behave as they do now, or they can work with counterparties to kill redundant trades; better yet, they can move it to an exchange. In any case, it will be their decision to run a complex book versus a simple one with less capital. If they choose complex books then they will accelerate the capital requirement.

This doesn't prevent banks from trading, but it does reduce unnecessary complexity by charging them appropriately. Complex trades are ones that require models or some other means of valuing. Massive capital charges and hard limits are required here. There should be no hedge accounting. If something needs to be complex and model driven, they can use it, but the capital has to assume the worst case -- that the position is far worse than anyone believes it could be. Complex postions should be treated differently than simple positions.

More Often Is Better Than Once
Capital charges should be based on an average of six days in a period rather than just some quarter end assessment (which is relatively easy to game). The average should be based on each month end, plus one day selected randomly by regulators, which should only be announced after close of business on the day that was selected. Banks can do this calculation in their sleep. If they can't do it, the question is, why not? How are they running their business without being able to analyze risk at the fairly basic levels these capital rules would require?

I think making the calculation something the banks face every day, rather than once a quarter, would go a long way to encouraging banks to carry excess collateral. They don't have the option of just cleaning it up for a nice and predictable quarterly report.

Funding Matters
This gets far more complex, but a bank that has nothing but short term financing is far riskier than one that only issued 10-year bonds. I'm not sure how to provide those benefits back to the banks that do the best job funding, but it should be a component of any regulatory overhaul.

Will this fix TBTF? No, but it seems fair. It allocates equity the way a hedge fund would. It is more complex than existing systems but protects against mistakes and unwinds. Small, simple banks will attract less capital as a percentage of assets than a small complex bank. And large complex banks will attract the capital that means if they "fail" they won't bring down the financial system. This could be applied to FDIC premiums or anything else, but it is time to start analyzing banks correctly from a regulatory standpoint.

Editor's Note: For more from Peter Tchir, check out TF Market Advisors.

Twitter: @TFMkts
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No positions in stocks mentioned.

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