Triggers for PCA

Financial Regulation Seminar

June 9, 2008

Thorvald Grung MoeNorges Bank (Central Bank of Norway)

The views presented are mine and should not be associated with Norges Bank

Outline

Background Key features of PCA PCA in Europe? Design of PCA triggers Policy issues Way forward

Background

Definitions

PCA = Prompt Corrective Action Rule-based intervention framework based on

specific levels of bank capital

FDICIA = Federal Deposit Insurance Corporation Improvement Act of 1991

SEIR = Structured Early Intervention and resolution (Benston and Kaufman, 1988)

Mandatory regulatory responses based on predetermined capital assets ratios that trigger structured actions by supervisors

Trigger event

How can we avoid another run?

Strengthen the financial system

Reducing likelihood of banks failing

Reducing the impact of failing banks

Renewed interest in PCA The Treasury Committee:

… see great merit in the “prompt corrective action” approach adopted in the US and in other countries.

We recommend that the judgment of the relevant authority, supplemented by a set of quantitative triggers, be used to identify whether a bank is either “failing”, at risk or failing, or is just an outlier in the industry.

Tripartite report – more reserved

… the interventions and powers available to the FSA are already wide-ranging

there may be cases in which there are practical problems with implementing (intervention) OIVOP powers (*)

… the authorities judges that the FSA requires a small number of additional powers

(*) Own Initiative Variation Of Permission

IMF support PCA type policy … the regime of remedial measures to be

applied against weak institutions crossing various thresholds established by the FSA could be further elaborated. Although the existing powers of the FSA to take action against weak institutions suffice, increasing clarity on the outcomes sought by regulators will lead to reduced ambiguity and would encourage early voluntary actions by weak financial institutions, for instance by reducing dividends and augmenting capital.

IMF Article IV Concluding Statement; May 23, 2008

Should FSA have spotted the crisis?

… there were a number of indicators emerging that could have prompted the supervisory team to re-assess its view of Northern Rock’s business risk much earlier (p. 42)

A number of signals were apparent that individually (and in aggregate) should have provided a trigger for a review of the structure of the balance sheet and the appropriateness of controls, … (p. 39)

FSA Internal Audit Report (March 2008)

Inadequate FSA resources Lack of management attention Last ARROW in march 2006

Letter to NR board: “Risk to FSA: LOW”

No Risk Mitigation Process (RMP) Supervisory period extended to 3 y Weak Close & Continuous process Liquidity review April 2007:

“No material weakness”

PCA Workshop in Norges BankMarch 2008

Issues for discussion

DO YOU THINK PCA REGULATION COULD BE USEFUL IN EUROPE?

HOW SHOULD PCA TRIGGERS BE DESIGNED AND USED?

WHICH REGULATORY ACTIONS SHOULD BE “TRIGGERED” - AND HOW FIXED SHOULD THE LINK BE BETWEEN TRIGGERS AND MANDATORY ACTIONS?

ANY OTHER RELEVANT ISSUES RELATED TO PCA TRIGGER IMPLEMENTATION IN EUROPE?

ConclusionNorges Bank workshop on PCA triggers, March 2008

PCA legislation is no panacea, but if implemented in a flexible and pragmatic manner, it could be a useful supplement to current EU regulations

PCA in context; related themes

Rules versus authority (Simons 1936)

Why prevention is better than cure (Goodhart 2007)

Banking regulation and PCA (Freixas and Pragi 2007)

Disclosure, volatility and transparency (Baumann 2004)

Formulas or supervision? (Estrella 1998)

The credit crisis and what it means (Soros 2008)

Key features of PCA

FDICIA -“Subtitle D”, Section 38

Mandates that each appropriate Federal banking agency … to take prompt corrective action to resolve the problems of insured depository institutions by prescribing or rescinding, as appropriate, specified capitalization measures established according to statutory guidelines (including capital restoration plan requirements)

FDICIA (1991): Bank classification and related capital levels

Capital levels

Total risk-based capital

Tier 1 risk-based capital

Tier 1 leverage ratio

Well Capitalized

≥ 10 % ≥ 6 % ≥ 5 %

Adequately capitalized

≥ 8 % ≥ 4 % ≥ 4 %

Undercapitalized

< 8 % < 4 % < 4 %

Significantly undercapitalized

<6% <3% <3%

Critically undercapitalized

Tangible equity ≤ 2%

Graduated supervisory response depending on capital category

Key provisions are [Sections 38 (d)–(i)] : No institution can pay dividends that will lead it

to be undercapitalized

Undercapitalized institutions will be monitored and have to provide a capital restoration plan; asset growth can also be restricted

Significantly undercapitalized institutions will (obviously) be subject to further restrictions

Critically undercapitalized institutions will be taken into receivership within 90 days

Mandatory – Discretionaryprovisions for undercapitalized banks

Restrict dividends No management

fees Capital restoration Restrict asset

growth Prior approvals for

branching etc. No brokered

deposits

Require new capital

Restrict affiliate transactions

Restrict rates on new deposits

Restrict activities Replace

management Require divestiture

Arguments in favour of a rule based approach to intervention

Increased credibility of supervisor Reduce scope for regulatory forbearance Reduce danger of undue political

interference Beneficial impact on bank behavior Reduce probability of future insolvency

Llewellyn & Mayes (2004)

Preconditions for PCA in Europe(*)

(*) See Nieto and Wall (2007) for details

Philosophy of SEIR/PCA

1. Minimize deposit insurance loss

2. Forbearance should be limited

3. Banks should be closed at positive capital levels

Institutional preconditions

1. Supervisory independence and accountability

2. Adequate authority

3. Adequate resolution procedures

4. Adequate and timely financial information

Discussion

CRD (and B II) have PCA elements Supervisory architecture different Supervisors prefer “broader” approach Elements of discretion even in FDICIA Discretion due to uncertain information=> Reluctance to embrace rule based

intervention, but emerging support for early resolution features of PCA

CRD/B II have PCA elements

B II/Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

CRD/Article 136: Competent authorities shall require any credit institution that does not meet the requirement of this Directive to take the necessary actions or steps at an early stage to address the situation.

Different supervisory architecture

US

Fed OCC FDIC

Europe

NCBincl. supervision

DGSPay box

Systemic concern Safety and soundness Least cost resolution

Supervisors prefer “modified” PCA approach

US Federal Reserve:

Regulators imposed formal action on banks long before their capital became undercapitalized.

PCA legislation may fill a few gaps, but may have been oversold.

Peek and Rosengren (1996)

Canada’s FSA (OSFI):

FDICIA was influential in shaping OSFI’s approach to intervention, but there was no direct importation.

Rather, the framework was rejected in its existing form.

Hard financial indicators were argued to be trailing rather than leading indicators of the financial health of an institution.

Black (2004)

OSFI: “Soft indicators”

The Guides to Intervention therefore incorporate ‘soft’ indicators, such as the strength of internal controls, internal policies on risk management and whether or not these were being followed, as well as figures on business growth in assessing financial health.

Broader supervisory approaches

ARROW = Advanced, Risk-Responsive Operating Frame-Work

FSA: The ARROW risk model

CapitalAsset QualityManagementEarningsLiquiditySensitivity to market risk

FED: CAMELS

Even some discretion in FDICIA

Section 38 (g): If an insured depository institution is

in an unsafe or unsound condition, … the agency may …

Reclassify the institution (“downgrade”) … Require the institution to comply with

(certain) provisions related to that capital category

Uncertain information => discretion

PCA encourage, but is not reliant on market value accounting

Paradox: PCA “rely on” effectiveness of supervisory examinations (Wall and Nieto 2007)

PCA ratings are lagging indicators of bank health (Peek and Rosengren 1996)

Interaction between accounting practices and financial crisis (Goodhart 2006)

Greater volatility => Stronger buffers

Emerging support for early closure

Special Resolution Regime (SRR) … to ensure that a range of tools are available to

take greater control of a failing bank

Special Resolution Regime (SRR) … should be based on regulatory triggers, in line

with principles in EU law governing the reorganization and winding-up of banks (!)

[= based on regulatory judgment by the FSA after consultation with BoE and HMT]

IMF support for SRR We support the aim of early intervention of distressed

institutions in the proposed SRR. It is not possible to identify in advance all

circumstances under which an institution should be put into the SRR process, but a definition of the circumstances likely to give rise to such a judgment would support this aim.

An approach whereby the regime is presumed to be triggered when a bank meets this definition strikes an appropriate balance between regulatory forbearance and unnecessary actions.

As thresholds for liquidity are hard to identify, discretion remains essential in this context.

IMF Article IV Concluding Statement; May 23, 2008

The problem of “signal error”

Banking crisis do not appear out of the blue

A high proportion were anticipated by our best leading indicators

There is a problem, however, of too many “false alarms” ~ one false for every 2-5 true signals

Goldstein (2000): Early warning system for financial crisis

Design of PCA triggers

Design of PCA triggers

10, 8, 3 or 0 %? Alternative triggers? Liquidity triggers? Link to Early Warning Systems Can we predict banking crises?

When to intervene? At 10, 8, 3 or 0 risk weighted capital?

Markets will react negatively if banks even approach regulatory minimum

Which type of crisis? Slow asset burn or

sudden liquidity crunch?

“90 days notice” if critically under-capitalized – realistic?

“… weakness leading to failure are often evident and addressed … well before the PCA capital triggers are met.”

Brunnmeir and Willardson (2006)

Perhaps not such a big issue?Very few banks are actually undercapitalized

CAMEL rating =>

PCA categorySubgroup A(rating 1 or 2)

Subgroup B(rating 3)

Subgroup C(rating 4 or 5)

Well capitalized 9149 485 70

Adequately capitalized

173 25 11

Undercapitalized 4 2 6

Distribution of US banks along PCA and CAMEL categories

Source: FDIC (2001)

Wider set of triggers? RBI will initiate

structured action if banks break any of these triggers: Capital to risk-

weighted assets ratio (CRAR)

Non-performing assets (NPA)

Return on Equity (ROE)

Source: Reserve Bank of India (2000)

PCA TRIGGERS (%)

CRAR < 9 < 6 < 3

NPA > 10, but < 15 > 15

ROE < 0,25

Perhaps also liquidity triggers?

FSA (2007): Liquidity is hard to predict! Liquidity risk can grow very rapidly

One suggested liquidity trigger: Request for emergency support facility

Other suggestions: Funding mismatch Short-duration liquidity shock

Which corrective action to associate? Close link with central bank ELA

Link to Early Warning Systems

New risk index estimated by Norges Bank gives strong and early signals of 1990-93 crisis banks

The risk index includes six indicators:1. The capital adequacy ratio

2. Ratio of residential mortgages to gross lending

3. An expected loss measure

4. A concentration risk measure

5. Return on assets

6. Norges Bank’s liquidity indicator

Early Warning Systems: Fantasy or Reality?

ECOFIN (2008) Considerations should be given to the

further development of early warning systems on individual (financial) institutions.

FSF (2008) Authorities must do all they can to

identify emerging problems so as to be able, if necessary, to take prompt appropriate action to mitigate them.

IMF Financial Soundness Indicators Core set

RWC NPL Sector % of loans ROA ROE Interest margin Cost ratio Liquid assets Net open FX position

Encourage set -additional data on: Deposit takers Other financial

institutions Non-financial

companies Households Market liquidity Real estate markets

Can we predict banking crises?

There are two traditional views of banking panics Crisis is generated by random events

(sunspots)=> bank run not due to any exogenous shock, or

Crisis is generated by fluctuations in fundamentals of the economy

Our theory … makes firm predictions about the conditions under which crisis will occur

Allen & Gale (2002)

But Goodhart’s law would kick in It is highly unlikely that a set of indicators could

be identified that could detect future crises sufficiently early and with a high degree of certainty, while not giving false signals.

Indeed, if such indicators could be identified they would likely lose their usefulness because they would change behavior; markets would take them into account and, by anticipating crises, precipitate them earlier, or policymakers would take actions to prevent crises from occurring. Consequently, the indicators would lose their ability to predict crises. IMF (1998): Economic Outlook

Something simple might do the trick: The leverage ratio

… it is essential that optimal risk-sensitive capital requirements be complemented by a capital floor that does not depend on the riskiness of banks’ activities.

Bichsel & Blum, April 2005

Reducing the leverage ratio would undermine our whole system of prompt corrective action which is the foundation stone of our system of supervision…

Former Comptroller of the Currency John Hawke, April 2004

PCA policy issues

Current PCA policy issues in Norway

Early intervention

1) Write down share capital

2) ELA conditions

Early resolution

3) Closing a bank and depositor payout

4) Bridge bank solution

1996 Act on Guarantee Schemes for Banks and Public Administration etc. Chapter 3: Payment

and capital adequacy difficulties

Chapter 4: Public Administration

Triggers for SEIR in the 1996 Act

WRITE-DOWN OF SHARE CAPITAL IF:

PUBLIC ADMINISTRATION IF:

one of these criteria is valid

a) The bank is probably illiquid

a) The bank is illiquid

a) Risk weighted capital may fall below 8 %

a) Risk weighted capital has fallen below 8 %

a) A large part of the bank’s equity is probably lost

a) A large part of the banks core capital is lost

1) Write down triggers in the Act

Write down possible according to the Act

However, write down may come too late?

Require new audited statement Could take some

time How to protect

shareholders right when time is short?

Chapter 4 (PA) + going concern may be better option?Based on large bank with Tier 1=8% and Tier 2=11,2%

Write down if …

Equivalent to Tier 2 capital of …

Corrective actions

A substantial part of equity is lost

7,6 % Call general assembly

More than 25 % of share capital is lost

5,8 % As above

Less than 25 % of share capital is left

4,6 % Write down share capital according to estimated losses

A substantial part of total capital is lost

1,6 % Write down subordinated debt

2) ELA policy issues (2004 – 2008)

Systemic

Solvency

Illiquid & solvent

Collateral

Current financial crisis has highlighted: Classic LLR case again

Illiquid, but solvent ELA despite RWC > 10% ELA only for systemic

banks with collateral But, obvious need for

CORRECTIVE ACTION Need to coordinate ELA

conditions with FSA Strengthen capital

position Engage shareholders

ELA policy issues

2004

2005 2006

20072008

3) Closing a bank and depositor payout (highlights from recent report)

A bank closure (public administration) today will be a challenge, even for small banks

If a bank is put into public administration, it is unlikely to reopen again

Public administration is (therefore) not a realistic resolution option for large banks

Depositors should expect partial payment within two weeks; the rest within 3 month

4) Bridge bank solution

How to maintain critical payment services, and write down non-protected creditors?

Policy dilemma Cannot be done under chapter 3 But chapter 4 (PA) will close the bank

Solutions Change law (US bridge bank/UK SRR) or Find “creative” solutions within current law

How to handle “TBTF” banks?

Important PCA elements for EU

Early resolution Provide incentive for market based crisis

resolution Could ease “burden sharing” discussion

Early intervention Fact finding: How do supervisors react to

breaches of regulatory capital today Common definition of solvency Convergence of supervisory reaction to declining

capital levels

Guidance for policy reform

PCA can be a very useful supplement Especially the ability to close early

Better to prevent crisis, but harder Focus should be on resolution policies

Write down, bridge bank, payout, etc.

Resolute handling of liquidity problems Better information systems Tight policy coordination FSA – NCB Enhanced role of owners

Way forward

Banking regulation at a crossroad:New regulations or just new attitudes?

Investors have lost confidence in banks

Bank stocks now trades at a book multiple of 1 – which is lowest level in15 years.

Changes to regulations are politically inevitable.

It appears certain that those changes will dent banks’ profits.

FT June 6, 2008

I don’t think we should lose sight of the fact that so much in regulation is not about structure, but about attitude and management: the “how” of regulation; the way it is done.

Sir Andrew Large (1997)

Way forward No silver bullet Goal: Resolve banking crises without

taxpayers money Prime responsibility for crisis resolution with

firm, owners and creditors Better & higher buffers would help

Plus self- & co-insurance How to resolve + maintain access to critical

payment services Has to deal with “TITF” (too interconnected to fail)

Changes in regulatory design?

Finding the right balance …

… there is a need for a sensible balance to be stuck between an early corrective action framework, and avoiding an excessive intrusive regulatory approach … and the development of excessively complex PCA triggers.

G. Kaufman (2004)

A balance need to be struck between rigid PCA regimes and general, less binding frameworks. One effective combination would include “automatic” rules for pre-agreed acceptable supervisory actions, plus room for flexibility in particular cases. BCBS (2002): Supervisory guidance on dealing with weak banks

Conclusion (repeat)Norges Bank workshop on PCA triggers, March 2008

PCA legislation is no panacea, but if implemented in a flexible and pragmatic manner, it could be a useful supplement to current EU regulations

References: F. Allen and D. Gale (2002). Financial fragility. U. Baumann (2004). Disclosure, volatility and transparency. J. Black. The development of risk based regulation in financial services: Canada, the UK and Australia. J. Blum and U. Birchler. Capital regulation of banks: Where do we stand and where are we going? Brunnmeir and Willardson (2006). Supervisory Enforcement Actions Since FIRREA and FDICIA. BCBS (2002): Supervisory guidance on dealing with weak banks A. Estrella (1998). Formulas or Supervision? Remarks on the future of regulatory capital. X. Freixas and B. Pragi (2007). Banking regulation and prompt corrective action. FSA (2008). The supervision of Northern Rock: a lessons learned review. C. Goodhart (2006): Why prevention is better than cure. M. Goldstein (2000). Implications of early warning models of crisis. HMT (2008). Financial stability and depositor protection: strengthening the framework. House of Commons, Treasury Committee (2008). The run on the Rock. FDIC (2001):Keeping the Promise: Recommendations for Deposit Insurance Reform. IMF (1998). Economic Outlook. IMF (2008). IMF Article IV Concluding Statement; May 23, 2008. G. Kaufman (2004). Musing on financial stability issues. Reserve Bank of New Zealand Bulletin. A. Large (1997). Regulation and reform. D. Llewellyn and D. Mayes (2004). The role of market discipline in handling problem banks. Nieto and Wall (2007). Preconditions for a successful implementation of supervisors' Prompt Corrective Action: Is

there a case for a banking standard in the EU? Peek and Rosengren (1996). Will Legislated Early Intervention Prevent the Next Banking Crisis? Reserve Bank of India (2000). Discussion paper on prompt corrective action. H.C. Simons (1936): Rules versus authority in monetary policy. G. Soros (2008). The New Paradigm for Financial Markets: The Credit Crash of 2008 and What It Means