Bank Capital and Derivatives

I've spent a bit of time recently thinking about how to model banks empirically and have come to the conclusion that it's quite difficult.  There are a number of theoretical models around, which do a good job of illustrating the connections between capital, lending, reserves and rates.  It's a useful exercise to play around with these and they are helpful in understanding the way these things are related.  I've particularly looked at the role of bank capital, as it has been crucial in shaping bank behaviour before and after the global financial crisis.

However, it get's much harder once you start to look at actual data.  There are various problems that emerge, but one of them struck me as quite interesting because it played an important part in the crisis itself.  This is the transformation of banks' balance sheets that has accompanied the growth of credit derivatives and the associated impact on the relationship between bank capital and risk.

A consultative document released by BIS this week on the revised leverage ratio framework makes some attempt to address this issue, but there are some good insights into the problems with the old capital framework in this report, particularly Annex 1.  This latter report deals with capital adequacy treatment of trading book transactions.  It is useful to elaborate on the distinction between banking book and trading book for regulatory capital purposes, as it helps explain one of the key ways in which derivatives contributed to the crisis.

The banking book covers loans.  Banks are required to hold capital based on the outstanding amount of loans on the banking book.  For most of the period prior to the crash, the amount of capital required for a given loan principal was based on some fairly simple rules, under which loans fell into one of a small number of different categories.

The trading book covers the bank's trading activities (obviously), where the bank may be taking positions in various markets, such as currency, equities and interest rates.   Capital is required against (amongst other things) market risk - the risk that market movements will lead to a loss.  Because trading positions are generally short term, capital is typically calculated on some estimate of possible market movements within a short time frame (a few days).  The idea is that because the positions can be traded and the bank has staff actively managing the position, the risk can be substantially mitigated by unwinding positions if the market moves adversely.

From around the beginning of the last decade, there was a massive growth in the market for traded credit, facilitated by the increased use of asset securitisation and of credit derivatives.  The use of these instruments increasingly enabled banks to hop in and out of counterparty credit positions that would historically have sat on the banking book.  This meant that it became possible to treat these positions as trading positions, subject to market risk based capital measures.

A traded credit position can take many forms.  However, in general the amount of capital required against the risk of a default by the underlying credit is significantly lower than that required on the banking book.  This makes sense as, in a very meaningful way,  there is less risk on the trading book.  Assets on the banking book sit there till maturity which may be many years.  The risk of things going wrong is much greater over several years than it is over a few days.

This difference in capital treatment created significant incentives to develop the traded credit market.  There were other reasons as well, notably the ability to sell assets to investors who were restricted to holding rating paper.  But for banks, traded credit was able to generate much higher returns on capital than could be earned on the banking book.  This tended to lead to more capital being allocated to traded credit and more and more credit risk being repackaged into tradable form.  At the same time, the reduced capital requirement meant that the same amount of capital was able to support greater and greater risk positions.  This fuelled a demand for more and more assets, pushing banks to take on credit risks that might otherwise have been unacceptable.

Notwithstanding the lower level of risk on traded assets, there is obviously a big flaw if you look at it from a system-wide point of view.  From a single bank's perspective, risk is reduced if they can exit a position quickly.  But the risk is still in the system and if everyone wants to exit at once, there's nowhere to go.  The risk assessment measures used to evaluate capital requirements were based on normal market conditions and did not adequately cover the more remote risks, including the possibility of the market seizing up.

The problem is that risk is not a linear quality.  One position can be unequivocally less risky than another in one sense, but be just as risky in others.  For example, if I were to place my life savings on the favourite to win the Derby, that would be less risky than if I placed it on a 100-1 outsider.  But there's also clearly a sense in which it just as risky - I still stand to lose my life savings.

An overwhelming proportion of bank losses in the financial crisis were realised in traded credit positions (or positions originally on the trading book and transferred when the markets seized up).  Of course, this is only one of a number of factors behind the financial crisis and it would be a mistake to look for a single cause.  However, the explosive growth of the traded credit market, facilitated by the development of credit derivatives and asset securitisation, was an important element in what happened.