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Paper by John Young of RBS on the contribution actuaries can make to banking
Citation preview
Understanding banking
What do banks do for customers
How do banks operate
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
Actuarial training is unique as it crosses siloes
bull Credit risk is analgous to underwriting
bull Provisioning is analgous to reserving
bull Bank capital management is like solvency
bull Liquidity risks can be understood through
bull behavioural assumptions
bull yield curve and duration matching reinvestment risks
bull Market risk is a given from asset models
bull Understand Accounting
bull Understand Economics
First the range of actuarial skills still unique
Automatically want to trade off risk and reward
bull Able to develop NPV pricing models
bull Able to build Customer Value models cross siloes
bull ldquoSeen as a ldquoneutral adviserrdquo on pricing
bull Can pick up random problems
Automatically look through time
bull 5 year plus horizon rather than 1 year margin
Consider risk or ruin
bull Philosophy like older bankers ndash first job is to protect savers
then think of maximising profits
As are actuariesrsquo ways of thinking
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
Services people need ndash payment transactions
bullProvide money transmission services
Services people need - cash flow management
bull Overdrafts revolving credit trade finance
bull Loans mortgages (Variable rate fixed rate)
Safe deposit ndash somewhere to keep savings
bull Current account savings accounts bonds
Long term savings and protection
bull Pensions investments life insurance
Banks exist to serve customerrsquos needs
Banks matter to society
bull Lend pound100
bull Spend pound100
bull Deposit pound100
bull Lend pound90 hellip
Cashflow management
Money transmission
Investment capital
Multiplier effect
Maturity transformation
Banks have a wider role to help society
Each of our current accounts canrsquot do much on their own
bull Balance is very volatile ndash can change daily
bull Balance is quite small
bull Individuals canrsquot usefully lend this to anybody as we donrsquot know when we
will spend it
bull This is ldquouseless money for societyrdquo
Banks add them together
bull A few million current accounts add up to a lot of balances
bull Added up these are much more stable
bull As these are stable they can be lent out
bull Used for mortgages investment in new business etc
bull Suddenly otherwise useless balances are being used by society
Zooming in
Maturity transformation
Zooming in
Multiplier effect
Great in the good times
bull Seems like a ldquomagical wayrdquo to create money
bull Fuels economic growth and expansion
bull Historically helped Britain defeat France in 1700rsquos ndash 1800s
bull But problem is when this goes into reverse
pound100 pound90
Deposit Loan
pound90 pound90
Deposit
pound81
Loan
Each time money is deposited assume ~ 90 is lent out
This creates a pattern of deposits hellip pound100 pound90 pound81 pound73 hellip
This is a geometric series that adds up to pound1000
Our original pound100 deposit can be lent out spent and deposited to make pound1000
[NOTE This is an over simplification of the process but it highlights how banks create
create money by lending See BOE WP 529]
Purchase
What do banks do for society
Multiplier effect ndash in reverse
Real issue for banking policy makers
bull When people are worried about the future they start to save more
bull They borrow less (so money supply falls money is ldquojust an IOUrdquo)
bull They spend less (so less is produced and employment falls)
This means that the multiplier effect we saw above can actually start to go into reverse
Reduced borrowing reduces deposits which can cause money supply to reduce and can
trigger a recession depression (Bank money is IOUs so as IOUs falls so does money)
Policy makers have been trying to avoid this
bull Encourage lending (base rate low at 05 and asset purchase scheme)
bull Funding for lending scheme
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
History
bull Merchants need somewhere safe to store their gold
bull Goldsmiths had big safes
bull Goldsmiths hold gold securely for a fee
bull But other merchants want to borrowhellip the gold smith can
lend out gold in his vault for another fee
Understanding what is a bank
Deposits
Lendin
g
A bank is an intermediary that manages a
balance sheet
Liability
(deposits)
margin
Asset
(loans)
bull Pay a rate to depositors to bring in savings
bull Receive a rate from lenders for lending out mortgages etc
bull The difference is the margin and this is what all banks strive to manage
bull Suitable for a 1 year PampL view ndash main difference to insurance
Borrowing and lending create a bankrsquos balance sheet
Lots of Short
term deposits Long term
mortgages
Short term cards
hellip through different conditions
Borrowing and lending create a bankrsquos balance sheet
Liability
(deposits)
margin
Asset
(loans)
5 2
3
bull Need to manage the margin through all interest rate conditions
bull This is why UK mortgages move onto SVR it offers a re-price point as the
interest rate world changes
bull The US offers gt 15 year fixed rate mortgages after the Great Depression and
this caused havoc with the Savings and Loans in the 80s as savings rates
soared
0
2
4
6
8
10
12
1
25
49
73
97
12
1
14
5
16
9
19
3
21
7
24
1
26
5
28
9
31
3
33
7
36
1
38
5
40
9
43
3
45
7
48
1
50
5
52
9
55
3
57
7
60
1
62
5
64
9
67
3
Banks manage margin through rate cycles
Savings Rate Loan Rate
Margin 3
History shows risks
bull Credit risk ndash loan not repaid [todayrsquos focus]
bull Liquidity risk ndash depositors all want their money back
at the same time But its been lent out
This creates two key risks a bank must manage
ldquoIrsquod like to
make a
withdrawalrdquo
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
Actuarial training is unique as it crosses siloes
bull Credit risk is analgous to underwriting
bull Provisioning is analgous to reserving
bull Bank capital management is like solvency
bull Liquidity risks can be understood through
bull behavioural assumptions
bull yield curve and duration matching reinvestment risks
bull Market risk is a given from asset models
bull Understand Accounting
bull Understand Economics
First the range of actuarial skills still unique
Automatically want to trade off risk and reward
bull Able to develop NPV pricing models
bull Able to build Customer Value models cross siloes
bull ldquoSeen as a ldquoneutral adviserrdquo on pricing
bull Can pick up random problems
Automatically look through time
bull 5 year plus horizon rather than 1 year margin
Consider risk or ruin
bull Philosophy like older bankers ndash first job is to protect savers
then think of maximising profits
As are actuariesrsquo ways of thinking
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
Services people need ndash payment transactions
bullProvide money transmission services
Services people need - cash flow management
bull Overdrafts revolving credit trade finance
bull Loans mortgages (Variable rate fixed rate)
Safe deposit ndash somewhere to keep savings
bull Current account savings accounts bonds
Long term savings and protection
bull Pensions investments life insurance
Banks exist to serve customerrsquos needs
Banks matter to society
bull Lend pound100
bull Spend pound100
bull Deposit pound100
bull Lend pound90 hellip
Cashflow management
Money transmission
Investment capital
Multiplier effect
Maturity transformation
Banks have a wider role to help society
Each of our current accounts canrsquot do much on their own
bull Balance is very volatile ndash can change daily
bull Balance is quite small
bull Individuals canrsquot usefully lend this to anybody as we donrsquot know when we
will spend it
bull This is ldquouseless money for societyrdquo
Banks add them together
bull A few million current accounts add up to a lot of balances
bull Added up these are much more stable
bull As these are stable they can be lent out
bull Used for mortgages investment in new business etc
bull Suddenly otherwise useless balances are being used by society
Zooming in
Maturity transformation
Zooming in
Multiplier effect
Great in the good times
bull Seems like a ldquomagical wayrdquo to create money
bull Fuels economic growth and expansion
bull Historically helped Britain defeat France in 1700rsquos ndash 1800s
bull But problem is when this goes into reverse
pound100 pound90
Deposit Loan
pound90 pound90
Deposit
pound81
Loan
Each time money is deposited assume ~ 90 is lent out
This creates a pattern of deposits hellip pound100 pound90 pound81 pound73 hellip
This is a geometric series that adds up to pound1000
Our original pound100 deposit can be lent out spent and deposited to make pound1000
[NOTE This is an over simplification of the process but it highlights how banks create
create money by lending See BOE WP 529]
Purchase
What do banks do for society
Multiplier effect ndash in reverse
Real issue for banking policy makers
bull When people are worried about the future they start to save more
bull They borrow less (so money supply falls money is ldquojust an IOUrdquo)
bull They spend less (so less is produced and employment falls)
This means that the multiplier effect we saw above can actually start to go into reverse
Reduced borrowing reduces deposits which can cause money supply to reduce and can
trigger a recession depression (Bank money is IOUs so as IOUs falls so does money)
Policy makers have been trying to avoid this
bull Encourage lending (base rate low at 05 and asset purchase scheme)
bull Funding for lending scheme
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
History
bull Merchants need somewhere safe to store their gold
bull Goldsmiths had big safes
bull Goldsmiths hold gold securely for a fee
bull But other merchants want to borrowhellip the gold smith can
lend out gold in his vault for another fee
Understanding what is a bank
Deposits
Lendin
g
A bank is an intermediary that manages a
balance sheet
Liability
(deposits)
margin
Asset
(loans)
bull Pay a rate to depositors to bring in savings
bull Receive a rate from lenders for lending out mortgages etc
bull The difference is the margin and this is what all banks strive to manage
bull Suitable for a 1 year PampL view ndash main difference to insurance
Borrowing and lending create a bankrsquos balance sheet
Lots of Short
term deposits Long term
mortgages
Short term cards
hellip through different conditions
Borrowing and lending create a bankrsquos balance sheet
Liability
(deposits)
margin
Asset
(loans)
5 2
3
bull Need to manage the margin through all interest rate conditions
bull This is why UK mortgages move onto SVR it offers a re-price point as the
interest rate world changes
bull The US offers gt 15 year fixed rate mortgages after the Great Depression and
this caused havoc with the Savings and Loans in the 80s as savings rates
soared
0
2
4
6
8
10
12
1
25
49
73
97
12
1
14
5
16
9
19
3
21
7
24
1
26
5
28
9
31
3
33
7
36
1
38
5
40
9
43
3
45
7
48
1
50
5
52
9
55
3
57
7
60
1
62
5
64
9
67
3
Banks manage margin through rate cycles
Savings Rate Loan Rate
Margin 3
History shows risks
bull Credit risk ndash loan not repaid [todayrsquos focus]
bull Liquidity risk ndash depositors all want their money back
at the same time But its been lent out
This creates two key risks a bank must manage
ldquoIrsquod like to
make a
withdrawalrdquo
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Actuarial training is unique as it crosses siloes
bull Credit risk is analgous to underwriting
bull Provisioning is analgous to reserving
bull Bank capital management is like solvency
bull Liquidity risks can be understood through
bull behavioural assumptions
bull yield curve and duration matching reinvestment risks
bull Market risk is a given from asset models
bull Understand Accounting
bull Understand Economics
First the range of actuarial skills still unique
Automatically want to trade off risk and reward
bull Able to develop NPV pricing models
bull Able to build Customer Value models cross siloes
bull ldquoSeen as a ldquoneutral adviserrdquo on pricing
bull Can pick up random problems
Automatically look through time
bull 5 year plus horizon rather than 1 year margin
Consider risk or ruin
bull Philosophy like older bankers ndash first job is to protect savers
then think of maximising profits
As are actuariesrsquo ways of thinking
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
Services people need ndash payment transactions
bullProvide money transmission services
Services people need - cash flow management
bull Overdrafts revolving credit trade finance
bull Loans mortgages (Variable rate fixed rate)
Safe deposit ndash somewhere to keep savings
bull Current account savings accounts bonds
Long term savings and protection
bull Pensions investments life insurance
Banks exist to serve customerrsquos needs
Banks matter to society
bull Lend pound100
bull Spend pound100
bull Deposit pound100
bull Lend pound90 hellip
Cashflow management
Money transmission
Investment capital
Multiplier effect
Maturity transformation
Banks have a wider role to help society
Each of our current accounts canrsquot do much on their own
bull Balance is very volatile ndash can change daily
bull Balance is quite small
bull Individuals canrsquot usefully lend this to anybody as we donrsquot know when we
will spend it
bull This is ldquouseless money for societyrdquo
Banks add them together
bull A few million current accounts add up to a lot of balances
bull Added up these are much more stable
bull As these are stable they can be lent out
bull Used for mortgages investment in new business etc
bull Suddenly otherwise useless balances are being used by society
Zooming in
Maturity transformation
Zooming in
Multiplier effect
Great in the good times
bull Seems like a ldquomagical wayrdquo to create money
bull Fuels economic growth and expansion
bull Historically helped Britain defeat France in 1700rsquos ndash 1800s
bull But problem is when this goes into reverse
pound100 pound90
Deposit Loan
pound90 pound90
Deposit
pound81
Loan
Each time money is deposited assume ~ 90 is lent out
This creates a pattern of deposits hellip pound100 pound90 pound81 pound73 hellip
This is a geometric series that adds up to pound1000
Our original pound100 deposit can be lent out spent and deposited to make pound1000
[NOTE This is an over simplification of the process but it highlights how banks create
create money by lending See BOE WP 529]
Purchase
What do banks do for society
Multiplier effect ndash in reverse
Real issue for banking policy makers
bull When people are worried about the future they start to save more
bull They borrow less (so money supply falls money is ldquojust an IOUrdquo)
bull They spend less (so less is produced and employment falls)
This means that the multiplier effect we saw above can actually start to go into reverse
Reduced borrowing reduces deposits which can cause money supply to reduce and can
trigger a recession depression (Bank money is IOUs so as IOUs falls so does money)
Policy makers have been trying to avoid this
bull Encourage lending (base rate low at 05 and asset purchase scheme)
bull Funding for lending scheme
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
History
bull Merchants need somewhere safe to store their gold
bull Goldsmiths had big safes
bull Goldsmiths hold gold securely for a fee
bull But other merchants want to borrowhellip the gold smith can
lend out gold in his vault for another fee
Understanding what is a bank
Deposits
Lendin
g
A bank is an intermediary that manages a
balance sheet
Liability
(deposits)
margin
Asset
(loans)
bull Pay a rate to depositors to bring in savings
bull Receive a rate from lenders for lending out mortgages etc
bull The difference is the margin and this is what all banks strive to manage
bull Suitable for a 1 year PampL view ndash main difference to insurance
Borrowing and lending create a bankrsquos balance sheet
Lots of Short
term deposits Long term
mortgages
Short term cards
hellip through different conditions
Borrowing and lending create a bankrsquos balance sheet
Liability
(deposits)
margin
Asset
(loans)
5 2
3
bull Need to manage the margin through all interest rate conditions
bull This is why UK mortgages move onto SVR it offers a re-price point as the
interest rate world changes
bull The US offers gt 15 year fixed rate mortgages after the Great Depression and
this caused havoc with the Savings and Loans in the 80s as savings rates
soared
0
2
4
6
8
10
12
1
25
49
73
97
12
1
14
5
16
9
19
3
21
7
24
1
26
5
28
9
31
3
33
7
36
1
38
5
40
9
43
3
45
7
48
1
50
5
52
9
55
3
57
7
60
1
62
5
64
9
67
3
Banks manage margin through rate cycles
Savings Rate Loan Rate
Margin 3
History shows risks
bull Credit risk ndash loan not repaid [todayrsquos focus]
bull Liquidity risk ndash depositors all want their money back
at the same time But its been lent out
This creates two key risks a bank must manage
ldquoIrsquod like to
make a
withdrawalrdquo
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Automatically want to trade off risk and reward
bull Able to develop NPV pricing models
bull Able to build Customer Value models cross siloes
bull ldquoSeen as a ldquoneutral adviserrdquo on pricing
bull Can pick up random problems
Automatically look through time
bull 5 year plus horizon rather than 1 year margin
Consider risk or ruin
bull Philosophy like older bankers ndash first job is to protect savers
then think of maximising profits
As are actuariesrsquo ways of thinking
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
Services people need ndash payment transactions
bullProvide money transmission services
Services people need - cash flow management
bull Overdrafts revolving credit trade finance
bull Loans mortgages (Variable rate fixed rate)
Safe deposit ndash somewhere to keep savings
bull Current account savings accounts bonds
Long term savings and protection
bull Pensions investments life insurance
Banks exist to serve customerrsquos needs
Banks matter to society
bull Lend pound100
bull Spend pound100
bull Deposit pound100
bull Lend pound90 hellip
Cashflow management
Money transmission
Investment capital
Multiplier effect
Maturity transformation
Banks have a wider role to help society
Each of our current accounts canrsquot do much on their own
bull Balance is very volatile ndash can change daily
bull Balance is quite small
bull Individuals canrsquot usefully lend this to anybody as we donrsquot know when we
will spend it
bull This is ldquouseless money for societyrdquo
Banks add them together
bull A few million current accounts add up to a lot of balances
bull Added up these are much more stable
bull As these are stable they can be lent out
bull Used for mortgages investment in new business etc
bull Suddenly otherwise useless balances are being used by society
Zooming in
Maturity transformation
Zooming in
Multiplier effect
Great in the good times
bull Seems like a ldquomagical wayrdquo to create money
bull Fuels economic growth and expansion
bull Historically helped Britain defeat France in 1700rsquos ndash 1800s
bull But problem is when this goes into reverse
pound100 pound90
Deposit Loan
pound90 pound90
Deposit
pound81
Loan
Each time money is deposited assume ~ 90 is lent out
This creates a pattern of deposits hellip pound100 pound90 pound81 pound73 hellip
This is a geometric series that adds up to pound1000
Our original pound100 deposit can be lent out spent and deposited to make pound1000
[NOTE This is an over simplification of the process but it highlights how banks create
create money by lending See BOE WP 529]
Purchase
What do banks do for society
Multiplier effect ndash in reverse
Real issue for banking policy makers
bull When people are worried about the future they start to save more
bull They borrow less (so money supply falls money is ldquojust an IOUrdquo)
bull They spend less (so less is produced and employment falls)
This means that the multiplier effect we saw above can actually start to go into reverse
Reduced borrowing reduces deposits which can cause money supply to reduce and can
trigger a recession depression (Bank money is IOUs so as IOUs falls so does money)
Policy makers have been trying to avoid this
bull Encourage lending (base rate low at 05 and asset purchase scheme)
bull Funding for lending scheme
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
History
bull Merchants need somewhere safe to store their gold
bull Goldsmiths had big safes
bull Goldsmiths hold gold securely for a fee
bull But other merchants want to borrowhellip the gold smith can
lend out gold in his vault for another fee
Understanding what is a bank
Deposits
Lendin
g
A bank is an intermediary that manages a
balance sheet
Liability
(deposits)
margin
Asset
(loans)
bull Pay a rate to depositors to bring in savings
bull Receive a rate from lenders for lending out mortgages etc
bull The difference is the margin and this is what all banks strive to manage
bull Suitable for a 1 year PampL view ndash main difference to insurance
Borrowing and lending create a bankrsquos balance sheet
Lots of Short
term deposits Long term
mortgages
Short term cards
hellip through different conditions
Borrowing and lending create a bankrsquos balance sheet
Liability
(deposits)
margin
Asset
(loans)
5 2
3
bull Need to manage the margin through all interest rate conditions
bull This is why UK mortgages move onto SVR it offers a re-price point as the
interest rate world changes
bull The US offers gt 15 year fixed rate mortgages after the Great Depression and
this caused havoc with the Savings and Loans in the 80s as savings rates
soared
0
2
4
6
8
10
12
1
25
49
73
97
12
1
14
5
16
9
19
3
21
7
24
1
26
5
28
9
31
3
33
7
36
1
38
5
40
9
43
3
45
7
48
1
50
5
52
9
55
3
57
7
60
1
62
5
64
9
67
3
Banks manage margin through rate cycles
Savings Rate Loan Rate
Margin 3
History shows risks
bull Credit risk ndash loan not repaid [todayrsquos focus]
bull Liquidity risk ndash depositors all want their money back
at the same time But its been lent out
This creates two key risks a bank must manage
ldquoIrsquod like to
make a
withdrawalrdquo
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
Services people need ndash payment transactions
bullProvide money transmission services
Services people need - cash flow management
bull Overdrafts revolving credit trade finance
bull Loans mortgages (Variable rate fixed rate)
Safe deposit ndash somewhere to keep savings
bull Current account savings accounts bonds
Long term savings and protection
bull Pensions investments life insurance
Banks exist to serve customerrsquos needs
Banks matter to society
bull Lend pound100
bull Spend pound100
bull Deposit pound100
bull Lend pound90 hellip
Cashflow management
Money transmission
Investment capital
Multiplier effect
Maturity transformation
Banks have a wider role to help society
Each of our current accounts canrsquot do much on their own
bull Balance is very volatile ndash can change daily
bull Balance is quite small
bull Individuals canrsquot usefully lend this to anybody as we donrsquot know when we
will spend it
bull This is ldquouseless money for societyrdquo
Banks add them together
bull A few million current accounts add up to a lot of balances
bull Added up these are much more stable
bull As these are stable they can be lent out
bull Used for mortgages investment in new business etc
bull Suddenly otherwise useless balances are being used by society
Zooming in
Maturity transformation
Zooming in
Multiplier effect
Great in the good times
bull Seems like a ldquomagical wayrdquo to create money
bull Fuels economic growth and expansion
bull Historically helped Britain defeat France in 1700rsquos ndash 1800s
bull But problem is when this goes into reverse
pound100 pound90
Deposit Loan
pound90 pound90
Deposit
pound81
Loan
Each time money is deposited assume ~ 90 is lent out
This creates a pattern of deposits hellip pound100 pound90 pound81 pound73 hellip
This is a geometric series that adds up to pound1000
Our original pound100 deposit can be lent out spent and deposited to make pound1000
[NOTE This is an over simplification of the process but it highlights how banks create
create money by lending See BOE WP 529]
Purchase
What do banks do for society
Multiplier effect ndash in reverse
Real issue for banking policy makers
bull When people are worried about the future they start to save more
bull They borrow less (so money supply falls money is ldquojust an IOUrdquo)
bull They spend less (so less is produced and employment falls)
This means that the multiplier effect we saw above can actually start to go into reverse
Reduced borrowing reduces deposits which can cause money supply to reduce and can
trigger a recession depression (Bank money is IOUs so as IOUs falls so does money)
Policy makers have been trying to avoid this
bull Encourage lending (base rate low at 05 and asset purchase scheme)
bull Funding for lending scheme
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
History
bull Merchants need somewhere safe to store their gold
bull Goldsmiths had big safes
bull Goldsmiths hold gold securely for a fee
bull But other merchants want to borrowhellip the gold smith can
lend out gold in his vault for another fee
Understanding what is a bank
Deposits
Lendin
g
A bank is an intermediary that manages a
balance sheet
Liability
(deposits)
margin
Asset
(loans)
bull Pay a rate to depositors to bring in savings
bull Receive a rate from lenders for lending out mortgages etc
bull The difference is the margin and this is what all banks strive to manage
bull Suitable for a 1 year PampL view ndash main difference to insurance
Borrowing and lending create a bankrsquos balance sheet
Lots of Short
term deposits Long term
mortgages
Short term cards
hellip through different conditions
Borrowing and lending create a bankrsquos balance sheet
Liability
(deposits)
margin
Asset
(loans)
5 2
3
bull Need to manage the margin through all interest rate conditions
bull This is why UK mortgages move onto SVR it offers a re-price point as the
interest rate world changes
bull The US offers gt 15 year fixed rate mortgages after the Great Depression and
this caused havoc with the Savings and Loans in the 80s as savings rates
soared
0
2
4
6
8
10
12
1
25
49
73
97
12
1
14
5
16
9
19
3
21
7
24
1
26
5
28
9
31
3
33
7
36
1
38
5
40
9
43
3
45
7
48
1
50
5
52
9
55
3
57
7
60
1
62
5
64
9
67
3
Banks manage margin through rate cycles
Savings Rate Loan Rate
Margin 3
History shows risks
bull Credit risk ndash loan not repaid [todayrsquos focus]
bull Liquidity risk ndash depositors all want their money back
at the same time But its been lent out
This creates two key risks a bank must manage
ldquoIrsquod like to
make a
withdrawalrdquo
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Services people need ndash payment transactions
bullProvide money transmission services
Services people need - cash flow management
bull Overdrafts revolving credit trade finance
bull Loans mortgages (Variable rate fixed rate)
Safe deposit ndash somewhere to keep savings
bull Current account savings accounts bonds
Long term savings and protection
bull Pensions investments life insurance
Banks exist to serve customerrsquos needs
Banks matter to society
bull Lend pound100
bull Spend pound100
bull Deposit pound100
bull Lend pound90 hellip
Cashflow management
Money transmission
Investment capital
Multiplier effect
Maturity transformation
Banks have a wider role to help society
Each of our current accounts canrsquot do much on their own
bull Balance is very volatile ndash can change daily
bull Balance is quite small
bull Individuals canrsquot usefully lend this to anybody as we donrsquot know when we
will spend it
bull This is ldquouseless money for societyrdquo
Banks add them together
bull A few million current accounts add up to a lot of balances
bull Added up these are much more stable
bull As these are stable they can be lent out
bull Used for mortgages investment in new business etc
bull Suddenly otherwise useless balances are being used by society
Zooming in
Maturity transformation
Zooming in
Multiplier effect
Great in the good times
bull Seems like a ldquomagical wayrdquo to create money
bull Fuels economic growth and expansion
bull Historically helped Britain defeat France in 1700rsquos ndash 1800s
bull But problem is when this goes into reverse
pound100 pound90
Deposit Loan
pound90 pound90
Deposit
pound81
Loan
Each time money is deposited assume ~ 90 is lent out
This creates a pattern of deposits hellip pound100 pound90 pound81 pound73 hellip
This is a geometric series that adds up to pound1000
Our original pound100 deposit can be lent out spent and deposited to make pound1000
[NOTE This is an over simplification of the process but it highlights how banks create
create money by lending See BOE WP 529]
Purchase
What do banks do for society
Multiplier effect ndash in reverse
Real issue for banking policy makers
bull When people are worried about the future they start to save more
bull They borrow less (so money supply falls money is ldquojust an IOUrdquo)
bull They spend less (so less is produced and employment falls)
This means that the multiplier effect we saw above can actually start to go into reverse
Reduced borrowing reduces deposits which can cause money supply to reduce and can
trigger a recession depression (Bank money is IOUs so as IOUs falls so does money)
Policy makers have been trying to avoid this
bull Encourage lending (base rate low at 05 and asset purchase scheme)
bull Funding for lending scheme
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
History
bull Merchants need somewhere safe to store their gold
bull Goldsmiths had big safes
bull Goldsmiths hold gold securely for a fee
bull But other merchants want to borrowhellip the gold smith can
lend out gold in his vault for another fee
Understanding what is a bank
Deposits
Lendin
g
A bank is an intermediary that manages a
balance sheet
Liability
(deposits)
margin
Asset
(loans)
bull Pay a rate to depositors to bring in savings
bull Receive a rate from lenders for lending out mortgages etc
bull The difference is the margin and this is what all banks strive to manage
bull Suitable for a 1 year PampL view ndash main difference to insurance
Borrowing and lending create a bankrsquos balance sheet
Lots of Short
term deposits Long term
mortgages
Short term cards
hellip through different conditions
Borrowing and lending create a bankrsquos balance sheet
Liability
(deposits)
margin
Asset
(loans)
5 2
3
bull Need to manage the margin through all interest rate conditions
bull This is why UK mortgages move onto SVR it offers a re-price point as the
interest rate world changes
bull The US offers gt 15 year fixed rate mortgages after the Great Depression and
this caused havoc with the Savings and Loans in the 80s as savings rates
soared
0
2
4
6
8
10
12
1
25
49
73
97
12
1
14
5
16
9
19
3
21
7
24
1
26
5
28
9
31
3
33
7
36
1
38
5
40
9
43
3
45
7
48
1
50
5
52
9
55
3
57
7
60
1
62
5
64
9
67
3
Banks manage margin through rate cycles
Savings Rate Loan Rate
Margin 3
History shows risks
bull Credit risk ndash loan not repaid [todayrsquos focus]
bull Liquidity risk ndash depositors all want their money back
at the same time But its been lent out
This creates two key risks a bank must manage
ldquoIrsquod like to
make a
withdrawalrdquo
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Banks matter to society
bull Lend pound100
bull Spend pound100
bull Deposit pound100
bull Lend pound90 hellip
Cashflow management
Money transmission
Investment capital
Multiplier effect
Maturity transformation
Banks have a wider role to help society
Each of our current accounts canrsquot do much on their own
bull Balance is very volatile ndash can change daily
bull Balance is quite small
bull Individuals canrsquot usefully lend this to anybody as we donrsquot know when we
will spend it
bull This is ldquouseless money for societyrdquo
Banks add them together
bull A few million current accounts add up to a lot of balances
bull Added up these are much more stable
bull As these are stable they can be lent out
bull Used for mortgages investment in new business etc
bull Suddenly otherwise useless balances are being used by society
Zooming in
Maturity transformation
Zooming in
Multiplier effect
Great in the good times
bull Seems like a ldquomagical wayrdquo to create money
bull Fuels economic growth and expansion
bull Historically helped Britain defeat France in 1700rsquos ndash 1800s
bull But problem is when this goes into reverse
pound100 pound90
Deposit Loan
pound90 pound90
Deposit
pound81
Loan
Each time money is deposited assume ~ 90 is lent out
This creates a pattern of deposits hellip pound100 pound90 pound81 pound73 hellip
This is a geometric series that adds up to pound1000
Our original pound100 deposit can be lent out spent and deposited to make pound1000
[NOTE This is an over simplification of the process but it highlights how banks create
create money by lending See BOE WP 529]
Purchase
What do banks do for society
Multiplier effect ndash in reverse
Real issue for banking policy makers
bull When people are worried about the future they start to save more
bull They borrow less (so money supply falls money is ldquojust an IOUrdquo)
bull They spend less (so less is produced and employment falls)
This means that the multiplier effect we saw above can actually start to go into reverse
Reduced borrowing reduces deposits which can cause money supply to reduce and can
trigger a recession depression (Bank money is IOUs so as IOUs falls so does money)
Policy makers have been trying to avoid this
bull Encourage lending (base rate low at 05 and asset purchase scheme)
bull Funding for lending scheme
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
History
bull Merchants need somewhere safe to store their gold
bull Goldsmiths had big safes
bull Goldsmiths hold gold securely for a fee
bull But other merchants want to borrowhellip the gold smith can
lend out gold in his vault for another fee
Understanding what is a bank
Deposits
Lendin
g
A bank is an intermediary that manages a
balance sheet
Liability
(deposits)
margin
Asset
(loans)
bull Pay a rate to depositors to bring in savings
bull Receive a rate from lenders for lending out mortgages etc
bull The difference is the margin and this is what all banks strive to manage
bull Suitable for a 1 year PampL view ndash main difference to insurance
Borrowing and lending create a bankrsquos balance sheet
Lots of Short
term deposits Long term
mortgages
Short term cards
hellip through different conditions
Borrowing and lending create a bankrsquos balance sheet
Liability
(deposits)
margin
Asset
(loans)
5 2
3
bull Need to manage the margin through all interest rate conditions
bull This is why UK mortgages move onto SVR it offers a re-price point as the
interest rate world changes
bull The US offers gt 15 year fixed rate mortgages after the Great Depression and
this caused havoc with the Savings and Loans in the 80s as savings rates
soared
0
2
4
6
8
10
12
1
25
49
73
97
12
1
14
5
16
9
19
3
21
7
24
1
26
5
28
9
31
3
33
7
36
1
38
5
40
9
43
3
45
7
48
1
50
5
52
9
55
3
57
7
60
1
62
5
64
9
67
3
Banks manage margin through rate cycles
Savings Rate Loan Rate
Margin 3
History shows risks
bull Credit risk ndash loan not repaid [todayrsquos focus]
bull Liquidity risk ndash depositors all want their money back
at the same time But its been lent out
This creates two key risks a bank must manage
ldquoIrsquod like to
make a
withdrawalrdquo
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Each of our current accounts canrsquot do much on their own
bull Balance is very volatile ndash can change daily
bull Balance is quite small
bull Individuals canrsquot usefully lend this to anybody as we donrsquot know when we
will spend it
bull This is ldquouseless money for societyrdquo
Banks add them together
bull A few million current accounts add up to a lot of balances
bull Added up these are much more stable
bull As these are stable they can be lent out
bull Used for mortgages investment in new business etc
bull Suddenly otherwise useless balances are being used by society
Zooming in
Maturity transformation
Zooming in
Multiplier effect
Great in the good times
bull Seems like a ldquomagical wayrdquo to create money
bull Fuels economic growth and expansion
bull Historically helped Britain defeat France in 1700rsquos ndash 1800s
bull But problem is when this goes into reverse
pound100 pound90
Deposit Loan
pound90 pound90
Deposit
pound81
Loan
Each time money is deposited assume ~ 90 is lent out
This creates a pattern of deposits hellip pound100 pound90 pound81 pound73 hellip
This is a geometric series that adds up to pound1000
Our original pound100 deposit can be lent out spent and deposited to make pound1000
[NOTE This is an over simplification of the process but it highlights how banks create
create money by lending See BOE WP 529]
Purchase
What do banks do for society
Multiplier effect ndash in reverse
Real issue for banking policy makers
bull When people are worried about the future they start to save more
bull They borrow less (so money supply falls money is ldquojust an IOUrdquo)
bull They spend less (so less is produced and employment falls)
This means that the multiplier effect we saw above can actually start to go into reverse
Reduced borrowing reduces deposits which can cause money supply to reduce and can
trigger a recession depression (Bank money is IOUs so as IOUs falls so does money)
Policy makers have been trying to avoid this
bull Encourage lending (base rate low at 05 and asset purchase scheme)
bull Funding for lending scheme
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
History
bull Merchants need somewhere safe to store their gold
bull Goldsmiths had big safes
bull Goldsmiths hold gold securely for a fee
bull But other merchants want to borrowhellip the gold smith can
lend out gold in his vault for another fee
Understanding what is a bank
Deposits
Lendin
g
A bank is an intermediary that manages a
balance sheet
Liability
(deposits)
margin
Asset
(loans)
bull Pay a rate to depositors to bring in savings
bull Receive a rate from lenders for lending out mortgages etc
bull The difference is the margin and this is what all banks strive to manage
bull Suitable for a 1 year PampL view ndash main difference to insurance
Borrowing and lending create a bankrsquos balance sheet
Lots of Short
term deposits Long term
mortgages
Short term cards
hellip through different conditions
Borrowing and lending create a bankrsquos balance sheet
Liability
(deposits)
margin
Asset
(loans)
5 2
3
bull Need to manage the margin through all interest rate conditions
bull This is why UK mortgages move onto SVR it offers a re-price point as the
interest rate world changes
bull The US offers gt 15 year fixed rate mortgages after the Great Depression and
this caused havoc with the Savings and Loans in the 80s as savings rates
soared
0
2
4
6
8
10
12
1
25
49
73
97
12
1
14
5
16
9
19
3
21
7
24
1
26
5
28
9
31
3
33
7
36
1
38
5
40
9
43
3
45
7
48
1
50
5
52
9
55
3
57
7
60
1
62
5
64
9
67
3
Banks manage margin through rate cycles
Savings Rate Loan Rate
Margin 3
History shows risks
bull Credit risk ndash loan not repaid [todayrsquos focus]
bull Liquidity risk ndash depositors all want their money back
at the same time But its been lent out
This creates two key risks a bank must manage
ldquoIrsquod like to
make a
withdrawalrdquo
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Zooming in
Multiplier effect
Great in the good times
bull Seems like a ldquomagical wayrdquo to create money
bull Fuels economic growth and expansion
bull Historically helped Britain defeat France in 1700rsquos ndash 1800s
bull But problem is when this goes into reverse
pound100 pound90
Deposit Loan
pound90 pound90
Deposit
pound81
Loan
Each time money is deposited assume ~ 90 is lent out
This creates a pattern of deposits hellip pound100 pound90 pound81 pound73 hellip
This is a geometric series that adds up to pound1000
Our original pound100 deposit can be lent out spent and deposited to make pound1000
[NOTE This is an over simplification of the process but it highlights how banks create
create money by lending See BOE WP 529]
Purchase
What do banks do for society
Multiplier effect ndash in reverse
Real issue for banking policy makers
bull When people are worried about the future they start to save more
bull They borrow less (so money supply falls money is ldquojust an IOUrdquo)
bull They spend less (so less is produced and employment falls)
This means that the multiplier effect we saw above can actually start to go into reverse
Reduced borrowing reduces deposits which can cause money supply to reduce and can
trigger a recession depression (Bank money is IOUs so as IOUs falls so does money)
Policy makers have been trying to avoid this
bull Encourage lending (base rate low at 05 and asset purchase scheme)
bull Funding for lending scheme
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
History
bull Merchants need somewhere safe to store their gold
bull Goldsmiths had big safes
bull Goldsmiths hold gold securely for a fee
bull But other merchants want to borrowhellip the gold smith can
lend out gold in his vault for another fee
Understanding what is a bank
Deposits
Lendin
g
A bank is an intermediary that manages a
balance sheet
Liability
(deposits)
margin
Asset
(loans)
bull Pay a rate to depositors to bring in savings
bull Receive a rate from lenders for lending out mortgages etc
bull The difference is the margin and this is what all banks strive to manage
bull Suitable for a 1 year PampL view ndash main difference to insurance
Borrowing and lending create a bankrsquos balance sheet
Lots of Short
term deposits Long term
mortgages
Short term cards
hellip through different conditions
Borrowing and lending create a bankrsquos balance sheet
Liability
(deposits)
margin
Asset
(loans)
5 2
3
bull Need to manage the margin through all interest rate conditions
bull This is why UK mortgages move onto SVR it offers a re-price point as the
interest rate world changes
bull The US offers gt 15 year fixed rate mortgages after the Great Depression and
this caused havoc with the Savings and Loans in the 80s as savings rates
soared
0
2
4
6
8
10
12
1
25
49
73
97
12
1
14
5
16
9
19
3
21
7
24
1
26
5
28
9
31
3
33
7
36
1
38
5
40
9
43
3
45
7
48
1
50
5
52
9
55
3
57
7
60
1
62
5
64
9
67
3
Banks manage margin through rate cycles
Savings Rate Loan Rate
Margin 3
History shows risks
bull Credit risk ndash loan not repaid [todayrsquos focus]
bull Liquidity risk ndash depositors all want their money back
at the same time But its been lent out
This creates two key risks a bank must manage
ldquoIrsquod like to
make a
withdrawalrdquo
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
What do banks do for society
Multiplier effect ndash in reverse
Real issue for banking policy makers
bull When people are worried about the future they start to save more
bull They borrow less (so money supply falls money is ldquojust an IOUrdquo)
bull They spend less (so less is produced and employment falls)
This means that the multiplier effect we saw above can actually start to go into reverse
Reduced borrowing reduces deposits which can cause money supply to reduce and can
trigger a recession depression (Bank money is IOUs so as IOUs falls so does money)
Policy makers have been trying to avoid this
bull Encourage lending (base rate low at 05 and asset purchase scheme)
bull Funding for lending scheme
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
History
bull Merchants need somewhere safe to store their gold
bull Goldsmiths had big safes
bull Goldsmiths hold gold securely for a fee
bull But other merchants want to borrowhellip the gold smith can
lend out gold in his vault for another fee
Understanding what is a bank
Deposits
Lendin
g
A bank is an intermediary that manages a
balance sheet
Liability
(deposits)
margin
Asset
(loans)
bull Pay a rate to depositors to bring in savings
bull Receive a rate from lenders for lending out mortgages etc
bull The difference is the margin and this is what all banks strive to manage
bull Suitable for a 1 year PampL view ndash main difference to insurance
Borrowing and lending create a bankrsquos balance sheet
Lots of Short
term deposits Long term
mortgages
Short term cards
hellip through different conditions
Borrowing and lending create a bankrsquos balance sheet
Liability
(deposits)
margin
Asset
(loans)
5 2
3
bull Need to manage the margin through all interest rate conditions
bull This is why UK mortgages move onto SVR it offers a re-price point as the
interest rate world changes
bull The US offers gt 15 year fixed rate mortgages after the Great Depression and
this caused havoc with the Savings and Loans in the 80s as savings rates
soared
0
2
4
6
8
10
12
1
25
49
73
97
12
1
14
5
16
9
19
3
21
7
24
1
26
5
28
9
31
3
33
7
36
1
38
5
40
9
43
3
45
7
48
1
50
5
52
9
55
3
57
7
60
1
62
5
64
9
67
3
Banks manage margin through rate cycles
Savings Rate Loan Rate
Margin 3
History shows risks
bull Credit risk ndash loan not repaid [todayrsquos focus]
bull Liquidity risk ndash depositors all want their money back
at the same time But its been lent out
This creates two key risks a bank must manage
ldquoIrsquod like to
make a
withdrawalrdquo
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Reminder of what actuaries can bring to banking
Big picture of services banking provides
bull What do banks do for customers
bull What do banks do for society
Big picture of how banks operate
bull At its simplest what do banks do
bull What risks does this inherently bring
bull How do banks (and regulators) manage these risks
Overview
History
bull Merchants need somewhere safe to store their gold
bull Goldsmiths had big safes
bull Goldsmiths hold gold securely for a fee
bull But other merchants want to borrowhellip the gold smith can
lend out gold in his vault for another fee
Understanding what is a bank
Deposits
Lendin
g
A bank is an intermediary that manages a
balance sheet
Liability
(deposits)
margin
Asset
(loans)
bull Pay a rate to depositors to bring in savings
bull Receive a rate from lenders for lending out mortgages etc
bull The difference is the margin and this is what all banks strive to manage
bull Suitable for a 1 year PampL view ndash main difference to insurance
Borrowing and lending create a bankrsquos balance sheet
Lots of Short
term deposits Long term
mortgages
Short term cards
hellip through different conditions
Borrowing and lending create a bankrsquos balance sheet
Liability
(deposits)
margin
Asset
(loans)
5 2
3
bull Need to manage the margin through all interest rate conditions
bull This is why UK mortgages move onto SVR it offers a re-price point as the
interest rate world changes
bull The US offers gt 15 year fixed rate mortgages after the Great Depression and
this caused havoc with the Savings and Loans in the 80s as savings rates
soared
0
2
4
6
8
10
12
1
25
49
73
97
12
1
14
5
16
9
19
3
21
7
24
1
26
5
28
9
31
3
33
7
36
1
38
5
40
9
43
3
45
7
48
1
50
5
52
9
55
3
57
7
60
1
62
5
64
9
67
3
Banks manage margin through rate cycles
Savings Rate Loan Rate
Margin 3
History shows risks
bull Credit risk ndash loan not repaid [todayrsquos focus]
bull Liquidity risk ndash depositors all want their money back
at the same time But its been lent out
This creates two key risks a bank must manage
ldquoIrsquod like to
make a
withdrawalrdquo
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
History
bull Merchants need somewhere safe to store their gold
bull Goldsmiths had big safes
bull Goldsmiths hold gold securely for a fee
bull But other merchants want to borrowhellip the gold smith can
lend out gold in his vault for another fee
Understanding what is a bank
Deposits
Lendin
g
A bank is an intermediary that manages a
balance sheet
Liability
(deposits)
margin
Asset
(loans)
bull Pay a rate to depositors to bring in savings
bull Receive a rate from lenders for lending out mortgages etc
bull The difference is the margin and this is what all banks strive to manage
bull Suitable for a 1 year PampL view ndash main difference to insurance
Borrowing and lending create a bankrsquos balance sheet
Lots of Short
term deposits Long term
mortgages
Short term cards
hellip through different conditions
Borrowing and lending create a bankrsquos balance sheet
Liability
(deposits)
margin
Asset
(loans)
5 2
3
bull Need to manage the margin through all interest rate conditions
bull This is why UK mortgages move onto SVR it offers a re-price point as the
interest rate world changes
bull The US offers gt 15 year fixed rate mortgages after the Great Depression and
this caused havoc with the Savings and Loans in the 80s as savings rates
soared
0
2
4
6
8
10
12
1
25
49
73
97
12
1
14
5
16
9
19
3
21
7
24
1
26
5
28
9
31
3
33
7
36
1
38
5
40
9
43
3
45
7
48
1
50
5
52
9
55
3
57
7
60
1
62
5
64
9
67
3
Banks manage margin through rate cycles
Savings Rate Loan Rate
Margin 3
History shows risks
bull Credit risk ndash loan not repaid [todayrsquos focus]
bull Liquidity risk ndash depositors all want their money back
at the same time But its been lent out
This creates two key risks a bank must manage
ldquoIrsquod like to
make a
withdrawalrdquo
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
A bank is an intermediary that manages a
balance sheet
Liability
(deposits)
margin
Asset
(loans)
bull Pay a rate to depositors to bring in savings
bull Receive a rate from lenders for lending out mortgages etc
bull The difference is the margin and this is what all banks strive to manage
bull Suitable for a 1 year PampL view ndash main difference to insurance
Borrowing and lending create a bankrsquos balance sheet
Lots of Short
term deposits Long term
mortgages
Short term cards
hellip through different conditions
Borrowing and lending create a bankrsquos balance sheet
Liability
(deposits)
margin
Asset
(loans)
5 2
3
bull Need to manage the margin through all interest rate conditions
bull This is why UK mortgages move onto SVR it offers a re-price point as the
interest rate world changes
bull The US offers gt 15 year fixed rate mortgages after the Great Depression and
this caused havoc with the Savings and Loans in the 80s as savings rates
soared
0
2
4
6
8
10
12
1
25
49
73
97
12
1
14
5
16
9
19
3
21
7
24
1
26
5
28
9
31
3
33
7
36
1
38
5
40
9
43
3
45
7
48
1
50
5
52
9
55
3
57
7
60
1
62
5
64
9
67
3
Banks manage margin through rate cycles
Savings Rate Loan Rate
Margin 3
History shows risks
bull Credit risk ndash loan not repaid [todayrsquos focus]
bull Liquidity risk ndash depositors all want their money back
at the same time But its been lent out
This creates two key risks a bank must manage
ldquoIrsquod like to
make a
withdrawalrdquo
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
hellip through different conditions
Borrowing and lending create a bankrsquos balance sheet
Liability
(deposits)
margin
Asset
(loans)
5 2
3
bull Need to manage the margin through all interest rate conditions
bull This is why UK mortgages move onto SVR it offers a re-price point as the
interest rate world changes
bull The US offers gt 15 year fixed rate mortgages after the Great Depression and
this caused havoc with the Savings and Loans in the 80s as savings rates
soared
0
2
4
6
8
10
12
1
25
49
73
97
12
1
14
5
16
9
19
3
21
7
24
1
26
5
28
9
31
3
33
7
36
1
38
5
40
9
43
3
45
7
48
1
50
5
52
9
55
3
57
7
60
1
62
5
64
9
67
3
Banks manage margin through rate cycles
Savings Rate Loan Rate
Margin 3
History shows risks
bull Credit risk ndash loan not repaid [todayrsquos focus]
bull Liquidity risk ndash depositors all want their money back
at the same time But its been lent out
This creates two key risks a bank must manage
ldquoIrsquod like to
make a
withdrawalrdquo
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
History shows risks
bull Credit risk ndash loan not repaid [todayrsquos focus]
bull Liquidity risk ndash depositors all want their money back
at the same time But its been lent out
This creates two key risks a bank must manage
ldquoIrsquod like to
make a
withdrawalrdquo
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Credit risk
Expected and unexpected losses
bull We allow for expected losses when setting lending rates and fees hellip but losses will
vary over time
bull Peak losses donrsquot occur every year but when they do they can be large
bull Like insurance companies probability of ruin
Figure 1
Time
Lo
ss r
ate
Expected
loss (EL)
Unexpected
loss (UL)Need a buffer in case of unexpected losses
Day to day business - price and make
decisions on expected losses
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Credit score cards are developed to
manage expected losses
The process is very like insurance underwriting
bull Score cards bring in a lot of customer data
bull Score cards built by looking at the correlation of this data against historic loss
bull Score cards use this past behaviour to rank customers in order of risk
Risk score
Pro
bab
ilit
y o
f d
efa
ult
bull Banks make money by taking risk and lending
bull The more accurately risk and expected loss can be predicted the easier it is to manage
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Expected loss will be priced into
credit lending decisions
The loan rate would normally allow for the following
Expected loss
Costs to write the loan
Cost of deposits
Profit
Sustainable loan rate includes
If we underestimate expected loss
we would underprice lending
Normally bad debts donrsquot arise until a few years after a loan is written (seasoning)
We may not know we have ldquomispriced risksrdquo until later
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
The rate and expected losses decide who banks
can lend to
bull Given a probability of loss banks can estimate the value fo a loan
bull This factors in income costs expected losses etc
bull At a certain rate and probability of loss the loan becomes negative value
bull This sets the minimum ldquocut offrdquo the bank should apply
PD
value
Customers with low PD create
positive returns
Customers with higher
PDs leads to losses
Break even score
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Risk based pricing ndash as yoursquod expect allows
lending to more customers
bull If banks charge a higher rate then customers who were unprofitable become
profitable
bull Banks can therefore lend to more customers at a higher rate
PD
value
Extra customers who can
get credit with risk based
pricing
6 Break even score
5 rate
15 rate 15 Break even score
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Credit risk Capital protects banks
from unexpected losses
Bank
Bank capital
Savers
Corporate
Borrowers
bull Loans
bull Mortgages
bull Cards
bullOverdrafts
Bank lends funds borrowed from savers and wholesale ndash amp its own capital
Banks hold capital to protect savers from unexpected losses
~ 10
~ 90
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
How much capital for two banks
Banks have same size of balance sheet of pound10bn
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
bull Are all risks the same
bull How can we get a handle on the riskiness of unexpected losses
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
It helps to break losses into 3 parts
Bank Measure What this measures
PD (Probability
of Default)
The risk a loan is not paid back in full
EAD (Exposure
at Default)
How much is owed when a loan defaults
Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back
If you owe pound1000 and pay back pound300 the LGD is 70
Credit Loss Loss = PD EAD LGD
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Loans are pretty simple to ldquoscenario testrdquo
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 70 80
Loss pound28 pound96
Difference for which we would need
capital
pound68
The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Secured lending is more complex
The loss given default is strongly influenced by how much the house is worth
relative to the mortgage
75 LTV 85 LTV 95 LTV
75 LTV 85 LTV 95 LTV
In the good times loans are all above water
As prices fall riskier loans are under water
LGD is zero when house prices are rising
Houses are sold for more than the
mortgage and the bank is repaid
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Changes in mortgage LGDs are very non-linear
in a downturn
0
5
10
15
20
25
30
35
0
4
8
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
10
0
Loss
Giv
en D
efau
lt
Loan to Value
Expected Loss Given Default for a mortgage
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a ldquohaircutrdquo
The losses are much worse in a
downturn
bull More impact on high LTVS
bull Even lower LTV mortgages affected
0
5
10
15
20
25
30
35
1 5 9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
10
1
Loss
Giv
e D
efau
lt
Loan to value
Downturn Loss Given default for a mortgage
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
So to estimate losses we need to estimate the
LTV mix of a ldquotypicalrdquo mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands
Work out average LGD for
ldquonormalrdquo conditions
Work out average LGD for
ldquodownturnrdquo conditions
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Loans (per pound1000)
Normal Downturn
PD (lifetime) 4 12
EAD pound1000 pound1000
LGD 082 132
Loss pound033 pound132
Difference for which we would need
capital
pound158
Complex mortgages become tractable to a
scenario test
Note because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by ldquodoublingrdquo the effective LGD
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Relative capital is quite different
Extra loss in downturn
Loans pound68
Mortgages pound15
=gt Loans need 4 times the capital in a downturn
We canrsquot yet answer how much to hold but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset Bank A Bank B
Cash 10 10
Mortgages 0 90
Loans 90 0
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
The Basel Rules came in to try and standardise
risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanyrsquos first world war reparations
A convenient location bordering France Germany and Switzerland later
led to it becoming a central bankers meeting ground
In the 1970s bank risks soared after a benign post war period
bull Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
bull Japanrsquo banks were on a capital light fuelled take over of the financial
arena
BIS introduced Minimum international standards named after its home
town in 1988
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Basel I set out a two stage process
Next convert RWAs into minimum capital requirements
Asset RWA
Cash 0
Mortgage 50
Corporate loan 100
Personal loan 100
First convert lending into relative measures of risk
bull Relative risk was measured in Risk Weighted Assets
RWAs were set out in standard tables
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Basel rules define two different types of capital
Tier 1 capital
The banks own money
bull Initial share issues
bull Rights issues (additional shares issued)
bull Retained profits
Very loss absorbing
Tier 2 capital
Like subordinated debt
Not be repaid until depositors get their money back
Only used if a bank fails This became a problem with ldquotoo big to failrdquo
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
The original minimum capital is pretty low
Regulatory MINIMUM capital calculated from RWAs
bull 4 Tier 1
bull 4 Tier 2
This is a level you stop being a bank
Regulators require more than this minimum
Actual minimum agreed with regulators
Banks now hold gt 10 Tier 1 capital
Regulators want to increase further
bull Basel III
bull Stress tests
bull Leverage ratio (the consultation we are responding to)
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Banks have an incentive to minimise capital
Assume
The ONLY difference if flash banks adopts a lower capital ratio
Lending by both needs 100 RWAS
Capital pound1bn
Capital ratio 80
Capital pound1bn
Capital ratio 125
Flash bank Steady bank
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
This immediately affects the banks profits
Capital pound1bn
Capital ratio 80
Assets lent pound125 bn
Profit pound125m
Capital pound1bn
Capital ratio 125
Assets lent pound83 bn
Profit pound83m
Flash bank Steady bank
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
And growth in profitability
Flash bank Steady bank
Capital ratio 80
Extra profits pound78m
Profit pound125m
Kept pound625m
Extra assets pound781m
Profit growth 625
Capital ratio 12
Extra profits pound346m
Profit pound83m
Kept pound415m
Extra assets pound346m
Profit growth 416
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Basel I distorted the banking landscape
Basel I ~ 1992
bull Simple rules focused on credit risk - no other risks included
bull RWA risk weightings defined for each type of loan
bull Not specific enough
Implications
bull Helped standardise capital
bull RWA do not reflect lending risk ndash Shell Oil needs same capital as a corner
shop
bull Tends to move banks up risk curve where they can get higher margin for
same RWAs
bull Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
And clear omissions led to initial tweaks
Basel I ~ update in 1996
bull Banks security trading was becoming more significant
bull Basel I 1996 update therefore brought in reference to market risk
bull Market risk assessment used internal Value at Risk or VAR approach
Implications
bull Banks were starting to outgrow Basel Irsquos simplicity
bull Securitisation allowed credit risk to move off balance sheet This distorted
business models to exploit capital arbitrage Eg Northern Rock
bull from 1997 to 2006 Assets grew pound13 - pound87bn (x 66)
bull Equity capital grew pound07 to pound17bn ( x24)
bull Tier 1 ratio went from 87 to 85
bull ldquoMiraclerdquo possible as securitisation left bank with capital deduction for
residual investment only This was often say ~ 15
bull This created a very exposed business model reliant on liquid markets
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
VARrsquos idea of internal assessment was
developed for credit risk with Basel II
Basel II ~ 2004 to 2008
bull Core idea is for banks capital to reflect bank specific risks
bull Calculated RWAs using banks own experience with PD EAD and LGD
bull Also provided increased disclosure in ldquopillars II and IIIrdquo
Loans
CalculatePDEAD LGDBy portfolios
RWAsBank specific
Loans
Internal Ratings (IRB) Standard Weightings
Loan RWA
Property 35
AAA ndash AA- 20
A+ - A- 50
BBB ndash BB- 100
lt BB- 150
More granular
look up
RWAs
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
IRB calculating RWAs from PD EAD and LGD
is rather complex
K is a correlation factor
It depends on the type of lending corporate mortgages credit cards
Also brought in limited capital requirements for operational risk Defined
around a percentage of income
The maths was neat but rather missed a more fundamental flaw
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Banks do this for various reasons
Higher ROE
bull Number of studies show lower capital for IRB
bull Design what is best for your bank
Its expected
bull Regulator expects demands
bull Shareholders expect banks to ldquoknow their own businessrdquo
bull Shows confidence in data
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
But to work well Basel II needs a nice steady
state world
To differentiate
between this risk
Basel II capital became
sensitive to through the cycle
risk
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
-15
-1
-05
0
05
1
15
12
54
97
39
71
21
14
51
69
19
32
17
24
12
65
28
93
13
33
73
61
38
54
09
43
34
57
48
15
05
52
95
53
57
76
01
62
56
49
67
3
Bank risk through the cycle Bank A
Bank B
Or else capital becomes ldquoprocyclicalrdquo
In a boom RWAs
and capital shrink
When you are making losses
and need more capital the
models increase the RWAs
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
-15
-1
-05
0
05
1
15
1 25 49 73 97 121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
Bank risk through the cycle Bank A
Bank B
Quite the opposite of Pharaoh in Genesis
Banking wisdom ndash party on
Biblical wisdom ndash save for famine
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
This shows clearly in FCA view of ROE
Before Basel II came in long period of low risks encouraged
leverage to boost ROE
bull Goldilocks economy
bull Great moderation
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
The financial crisis hit before Basel II was
fully implemented
The crisis highlighted various issues
bull Pricing was too low
bull Tier 1 capital was too low in level and too low in ldquoqualityrdquo
bull Tier 2 capital was pointless in a ldquotoo big to failrdquo world
bull Too focused on credit risk not liquidity issues
Implications
bull Central Bankers have started to look at a range of new measures
bull Ring fencing retail and investment banking plus living wills
bull Basel III proposed
bull Stress testing becoming more serious
bull New provisioning rules ndash IFRS9
bull Proposals for a leverage ratio
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
The crisis highlighted issues with pricing risk ndash
BOE view of UK high yield corporates
Sources Bloomberg Merrill Lynch Thomson Datastream and Bank calculations
BOE April 2007 Financial Stability Report The decomposition assumes a debt maturity of 20 years For details see Churm
R and Panigirtzoglou N (2005) lsquoDecomposing credit spreadsrsquo Bank of England Working Paper no 253
Margins falling as
credit expands
Banks max out on
credit just in time for
major losses
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
The crisis also highlighted a lack of capital ndash
BOE chart for historic US amp UK capital ratios
Sources Berger A Herring R and Szegouml G (1995) lsquoThe role of capital in financial institutionsrsquo Journal of Banking and Finance pages 393ndash430 United Kingdom
Billings M and Capie F (2007) lsquoCapital in British banking 1920ndash1970rsquo Business History Vol 49(2) pages 139ndash62
British Bankersrsquo Association and published accounts
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets) UK data show
risk-
weighted Tier 1 capital ratios for a sample of the largest banks
(b) National Banking Act 1863
(c) Creation of Federal Reserve 1914
(d) Creation of Federal Deposit Insurance Corporation 1933
(e) Implementation of Basel risk-based capital requirements 1990
(f) From Billings and Capie (2007)
(g) BBA and Bank calculations This series is not on exactly the same basis as 1920ndash70 so comparison of levels is merely indicative
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
And declines in quality ndash BOE data on UK bank
Tier 1 make up
Sources Dealogic published accounts and Bank calculations
(a) Includes Abbey Alliance and Leicester and Bradford and Bingley instead of Banco Santander
Excludes Northern Rock
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Basel III (2013 ndash 2018) seeks to plug some gaps
Better definition of Capital
bull We have described Tier 1 capital as retained profit
bull Profit is an accounting concept that includes goodwill Deferred Tax Assets
Pension Fund shortfalls etc
bull Basel III thus standardises deductions to calculate Tier 1 capital
bull This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)
Liquidity issues
Liquidity Coverage Ratio (LCR)
bull Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
bull Ratio of sticky deposits to longer term lending
bull To protect against too great term mismatch to profit from normal yield curve
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Basel III (2013 ndash 2018) seeks to plug some gaps
Increase in capital held for trading risks
bull Capital is held against tail risk
bull VAR is modelled based on normal conditions ndash so by definition methodology is a
disaster for tail risk
bull Basel II5 has ldquostressed VARrdquo
bull Basel III may moved to expected short fall approach to try and use realistic
scenarios
bull Introduces capital fro Counterparty risk (Credit Valuation Adjustment ndash CVA)
Leverage Ratio
bull Crude ratio of capital to assets
bull Will affect banks with low RWAs
bull UK further and faster than most
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
Some other stuff sits outside
Stress testing
bull Bigger in US than UK
bull May end up setting capital floor to pass stress tests
bull Stresses income losses and capital
bull Should capture procyclical risks such as capital or provisions under IFRS9
bull Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage
IFRS9
bull Accountants play with probabilistic risks
bull Increased IBNR versus current provisioning that relies on actually going
bad
bull Significant operational issues raised by proposals
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
New rules need to balance out risk of
triggering a problem
Regulators can make banks safer with more capital
bull Holding more capital reduces risk from lending
bull Holding Tier 1 capital makes a bank safer
However too much capital will impact the economy
bull Banks improve capital ratios by cutting back on lending
bull This impacts the multiplier effect mentioned earlier
bull Banks reduce riskier lending (eg higher LTV mortgages)
bull Banks expand lending more slowly as retained profits support
less future lending
bull Cost of capital may be passed onto customers
