The new name for City University Business School Alistair Milne Senior Lecturer in Banking and Finance 7 th February, 2006

The new name for City University Business School

Alistair Milne

Senior Lecturer in

Banking and Finance

7th February, 2006


Do Banks really need Pillar 1 IRB compliance?

Alistair Milne

Cass Business School

[email protected] http://www.cass.city.ac.uk/faculty/a.milne/

PRIMIA/ISDA meeting, London

February 7th, 2006

mailto:[email protected]

http://www.cass.city.ac.uk/faculty/a.milne/




Overview• WACC calculations: lower regulatory capital

may not worth so very much

• Problems with capital allocation– lack of data, we can’t really measure the tail– RAROC sometimes inconsistent with market pricing

• The way forward: distinguish economic capital and prudential (regulatory) capital

– RAROC can be made to work better when not tail focussed

– Tensions with regulators reduced, when they are not interfering in business decisions

• Is IRB business relevant?– Yes, but not for the reductions in capital


WACC calculations


What competitive advantage?

• Proposition 1: lower regulatory capital provides

me with a competitive advantage

• Proposition 2: estimating tail risks and allocating economic capital provides me with a competitive advantage

• Both must be qualified– Competitive advantage of lower regulatory capital is

small– Tail risks relatively unimportant to pricing


WACC arguments• WACC = weighted average cost of capital

– Sum of debt and equity components

• Equity capital small proportion of total funding

• Higher (lower) regulatory capital may result in less than 1:1 impact on equity capital– e.g. if following rating agency assessments

• Higher (lower) regulatory capital makes equity capital less (more) risky, lowers (raises) cost of equity– Assuming perceived risk not affected by regulatory

requirements


Table 3: Change in cost of mortgage lendingS ta n d ar da p p r oa c h

IR B C h a n g e

V a lu e of loa n s € (1 ) 1 0 0 .0 1 0 0 .0R isk w eigh tin g (2 ) 5 0 % 2 5 %C a p ital re qu ire m en t: tie r 1 € (3 ) (1 ) (2 ) 4 % 2 .0 1 .0 -1 .0C a p ital re qu ire m en t: tie r 2 € (4 ) (1 ) (2 ) 4 % 2 .0 1 .0 -1 .0

C os t of T ier 2 d e bt e m p loye d € (5 ) (4 ) 5 % 0 .1 0 .1C os t of o th e r d eb t e m plo ye d € (6 ) [(1 ) - (3) - (4)] 5 % 4 .8 4 .9G ross cos t of d eb t e m plo ye d € (7 ) (5 ) + (6) 4 .9 5 .0T a x € (8 ) -(7 ) 3 0% -1 .5 -1 .5A fte r tax cos t of d e b t e m ploye d € (9 ) (7 ) + (8) 3 .4 30 3 .4 65 0 0 .0 35

L e ve ra ge a d ju ste d C O E (1 0) 4 % + [1 5% - 4% ] (2 ) 1 (2) 2 ] 1 5 .00 % 2 6 .00 %

A fte r tax cos t of t ier 1 e q uity € (11) (3 ) (10 ) 0 .3 0 0 .2 6 -0 .0 4 0

A fte r tax b rea k e ve n loa n ch a rge (1 2) [(9 ) + (11 )] (1) 3 .7 30 % 3 .7 25 % -0 .0 0 5%P re ta x b re a k e ve n loa n ch a rge (1 3) (1 2) [1 - 30 % ] 5 .3 29 % 5 .3 21 % -0 .0 0 7%

H u rd le in te re st rate o n len d in g

R e d u c e d IR B ca p ital r e q uire m e n t for m or tg a ge s

R e g u la tory re q uirem en ts

C o s t of d e bt

C o s t of e q uity


Conclusions on reg cap• Total regulatory capital in UK commercial

banking sector reduced by 15% (advanced Basel II versus Basel 1988)– Mortgage reg cap by 25%

• But £1mn of reg cap worth lot less than £1mn shareholder value

• If we assume 1:1 impact, ignore “leverage effect” increases cost of funding by less 5 bp– With leverage adjustment, less than 1 bp– Main impact the tax advantages of debt (maybe

£1mn reg cap = £100,000 shareholder value)


Problems with capital allocation


“Economic capital”: Logic• Equity capital to maintain AA rating,

commonly 99.97% on one year horizon– average AA default frequency .

• Equity capital is in limited supply– ration according to rate of return– sometimes related to “return on equity”


Data problems – credit risk• Larger corporates/ sovereigns fairly OK

– CreditMetrics/MKMV– US ratings history back to 1950s or earlier– Difficulties with LGD

• Retail (including smaller corporates): – a variety of scoring models, good for PD– a little work on CVaR– best UK institutions around 10-12 years data

• UK FSA transitional arrangements accept 5 years of data for Basel computations! 2 years for LGD

• Other low default portfolios, – even more severe data problems

• Correlations?


Data problems – op risk• Even greater than for credit risk

• High frequency/ low impact– Most firms have databases, for a few years– Little comparability between firms– Mostly EL (minor contribution to EC)

• Low frequency/ high impact– By their nature no data– Low correlation with market/ credit risks?


Result is dishonesty!• We lack data, so instead of the impossible

(99.97%) we extrapolate – standard deviations, using arbitrary multipliers– PD as in Basel risk curves (Vasicek single factor model plus

arbitrary correlation loading)

• OP risk : low frequency high impact AMA , no statistical basis at all

• We are confusing:– Risk/return tradeoff (does not need extreme tail)– prudential safety (does not need statistics)


RAROC difficulty (1)• Liquidity facilities

– eg Lines of credit to a AAA/AA corporates– eg commercial paper underwriting

• Bank backs such exposures with capital– to maintain liquidity over (say) 24 months

• Loss highly unlikely: 99.98% appropriate• VERY safe lending, outside tail no risk at

all!– 15% required return on this committed capital leads

to unreasonably high pricing …– Cannot compete with market prices


RAROC difficulty (2)• Capital in trading operations

• Liquidity is “lifeblood”, need to survive temporary market fluctuations without being forced to close positions

• Well known examples LTCM, Metallgesellschaft

• Investors (shareholders) need to distinguish extreme tails and normal range of market fluctuations, only latter is priced risk


RAROC difficulty (cont)• Underlying issue is “skewness of returns”

• Shareholder concern is in obtaining enough return to compensate for risk– Can be computed as “NPV” net present

value

• NPV calculation approximated by RAROC– But may overstate costs of diversifiable risk– And penalises investment returns with sharp

left skew


Some tentative solutions


How to make RAROC work• Don’t focus on extreme tail risk

– use standard deviation of returns• allow for diversification (eg portfolio or market beta)

– or calibrate to e.g. 95% threshold

• Different from prudential capital– This is minimum capital, an inequality

• no real cost to having even more capital (risk unchanged)

– 99.97 appropriate, but do not pretend at precision– Deal with data problems by being very conservative– Use standarized scenarios (inc. op risk events)


Reducing reg cap via IRB?• Makes NO difference to risk

– So should be totally excluded from RAROC

• Fits with Modgliani-Miller (1958, 1961)– Capital structure is irrelevant– But there are tax effects

• So you may want to seek out IRB tax gains

• IRB has no other competitive impact– So no little or no customer impact


Implication for Basel accord• Pillar I is over-engineered

– Confuses data based risk measurement with prudent capital standards

– No reason to closely align regulatory and economic capital

• Minimise costs of Basel compliance– Focus on own model building– Choose minimum compliance cost e.g. foundation

IRB, standardized approach to Op Risk– Use scenarios for Pillar 2 ICAAP


Implications for capital allocation

• Base economic capital on low threshold (95%) or standard deviations

• Correlation with market is better than portfolio correlation and easier

• Op Risk– Don’t allocate low frequency high impact– High frequency low impact in Expected Cost


Final remarks


What competitive advantage?

• Proposition 1: lower regulatory capital provides me with a competitive advantage

• Proposition 2: estimating tail risks and allocating economic capital provides me with a competitive advantage

• Both must be qualified– Competitive advantage of lower regulatory capital is

small– Tail risks relatively unimportant to pricing


Summary: prudence v. risk• Prudential capital

– banks must be credit worthy, even in the most adverse circumstances (extreme tails)

• Risk versus return– bank interest margins/ fees/ trading returns compensation for

entire distribution of risk (use sd or low threshold like 95%)

• Confusing the two can lead to either overpricing or insufficient capital backing

• Regulatory capital (IRB) is of no direct business relevance– Except good to show the world you can do it


Further reading…• Three lessons on Bank Capital Allocation

– Alistair Milne, March 2006

• Analysis of impact of IRB on funding costs– Giles and Milne (2004) (around 1 basis pt!, tax

effect only)

• Some of my academic contributions:– Dimou, Lawrence, and Milne (2005)– Milne and Onorato (2005a, 2005b)– Lawrence and Milne (2004)

Documents

The new name for City University Business School Alistair Milne Senior Lecturer in Banking and Finance 7 th February, 2006