Basel II: Do Big Banks Need More Capital?

by: Christopher Whalen

"The Basel Committee on Banking Supervision, in its October meeting, believes that the implementation of the Basel II capital framework would have gone some distance to alleviate the current global credit crunch which has resulted from the sub-prime lending crisis. Nout Wellink, the chairman of the Basel Committee on Banking Supervision observed that the accord is designed to combat liquidity risk and would have improved the robustness of valuation practices and market transparency for complex and less liquid products." - Chase Cooper, October 11, 2007

With all due respect to the Nout Wellink and the other members of the BCBS, we do not believe that the implementation of the Basel II proposal or anything that looks remotely like it would have alleviated the ongoing collapse of the market for complex structured assets. When an entire asset class literally dies in a matter of weeks, the risk is infinite. To us, measuring the liquidity or market risk of a Structured Investment Vehicle ("SIV"), with or without the Basel II framework, makes about as much sense as using statistics to predict corporate credit defaults.

Remember too that most of Basel II is based upon the very quantitative models and rating agency methods which caused the subprime crisis, thus offers of assistance from Basel II's creators within the BCBS should be viewed with caution. Basel II merely mimics the business processes of the Sell Side investment houses, systems which are intended first to enable new financial transactions and, as a secondary matter, manage the risk. See our comment in the American Banker regarding same. If you want to know what we really think, read our comments to US regulators on the Basel II proposal.

The quarter trillion dollar financial sinkhole caused by the collapse of the market for structured subprime assets illustrates, to us at least, why a rational implementation of Basel II should require MORE CAPITAL for large universal banks. These are institutions which emphasize unpredictable business lines such as principal trading, creating and selling OTC derivatives, and investment banking, but also take risk in lending and other traditional banking activities. Citigroup (NYSE:C) is an excellent example of a bank facing rising risks from both quarters.

Or take the unhappy example of Ken Lewis, CEO of Bank of America (NYSE:BAC). He said last week regarding the poor performance of his second-tier investment banking shop: "I have had all of the fun I can stand in investment banking at the moment. So to get bigger [in investment banking] is not really something I want to do." BAC has a pretty modest trading book risk exposure and a top-performing banking book compared to asset peers, so you can understand why Lewis is seriously pissed off when his investment bankers drop the ball.

No matter which large global bank you choose, the portion of bank earnings attributable to capital markets activities is neither stable nor predictable, especially when derivatives (and investment bankers) are involved. Even a bank with a relatively small banking business like BAC can take a "surprise" hit from the trading book. What neither regulators nor bankers nor Sell Side researchers will admit, though, is that periodic "surprises" are the norm for universal banks, thus arguments about Basel II allowing banks to maintain less capital are patently ridiculous.

To understand our skepticism about the ability of banks to manage their trading books "safely and soundly," particularly using derivative tools such as VaR and Merton models which populate the Basel II framework, consider the words of physicist Stephen Hawking from his lecture Does God Play Dice?:

The idea that the state of the universe at one time determines the state at all other times, has been a central tenet of science, ever since Laplace's time. It implies that we can predict the future, in principle at least. In practice, however, our ability to predict the future is severely limited by the complexity of the equations, and the fact that they often have a property called chaos. As those who have seen Jurassic Park will know, this means a tiny disturbance in one place, can cause a major change in another. A butterfly flapping its wings can cause rain in Central Park, New York. The trouble is, it is not repeatable. The next time the butterfly flaps its wings, a host of other things will be different, which will also influence the weather. That is why weather forecasts are so unreliable.

Risk within the largest banks, on and off balance sheet, has risen exponentially over the past half century. Gaming instruments like cash settlement derivatives and structured assets are the preferred "investment" vehicles of the Sell Side firms, but these instruments and the humans who create and trade them add a huge degree of complexity and unpredictability to the financial behavior of these banks. And the proposed Basel II agreement, far from constraining this trend toward greater and greater risk taking and complexity, will enable banks to extend risk taking further and further into unpredictable areas which were once forbidden for depository institutions.

In view of the current market meltdown caused by "SIVs" and other types of derivatives, we think it is reasonable to ask whether under Basel II large universal banks with significant trading book activities don't need more capital than under Basel I. Three years ago, IRA asked that very question and set about estimating the amount of Economic Capital required to keep a bank's external credit rating stable in the face of a serious loss to the trading book. We used the portfolio-level data from the FDIC to create a consistent measure of Economic Capital for all US banks.

Below is a summary of the Economic Capital model in the IRA Bank Monitor for the 20 largest US banks by total assets. Institutions whose ratio of Economic Capital to Tier One Risk Based Capital ("RBC") exceeds one standard deviation from the average for all banks over $100 billion in total assets are shown in red. The SD for the large bank group was 1.7:1 while the mean was 1.3:1. A low or negative Risk Adjusted Return on Capital or "RAROC" may indicate an institution with excessive risk and/or inferior asset and equity returns.

The IRA Bank Monitor -- Economic Capital (June 30, 2007)

Source: Federal Deposit Insurance Corp/The IRA Bank Monitor

These Economic Capital profiles reflect not only the "on balance sheet" assets of the subsidirary banks of these holding companies, but also off balance sheet derivatives dealing, and include an analysis of trading, investing and lending activities. The growing trading book risk of the largest banks argues strongly in favor of requiring more capital to support these activities. Institutions such as C and JPMorgan (NYSE:JPM) which engage in extensive derivatives dealing with and lending to hedge funds, and/or off-balance sheet financial activities using SIVs, should arguably be given higher ratios of EC/Tier One RBC, subject to credible mitigation.

While many large banks appear to need additional capital, it is worthy of note that the average ratio of Economic Capital to Tier One RBC for the other 8,000 plus banks in the US is well-below 1:1. This suggests that smaller, less complex banks could get by with far less capital and thereby significantly boost equity returns.

Looking at Economic Capital based upon published regulatory disclosure seems, to us at least, a basic point of departure for making Basel II a truly useful tool for maintaining the safety and soundness of all banks. While the larger players in the banking industry once saw Basel II as a means of further increasing leverage and risk-taking, the subprime crisis may provide regulators with a lever to compel banks to hold more capital against visible and contingent risks such as SIVs. But do bodies like the BCBS have the courage to fight that battle?